“Positively Evil”

Felix Salmon has written a good piece on the behavior of the investment banks that bought, securitized, and sold mortgages in the years leading up to the crisis (emphasis added, bold only):

…[Investment banks] tested only a small portion of the loans in [a] pool [of mortgages]. So [they] knew that if there were a bunch of bad loans [discovered by testing], there were bound to be even more bad loans among the loans that…had not [been] tested. And those loans it couldn’t put back to the originator, because [they] didn’t know exactly which loans they were.

If there had been any common sense in the investment banks, that would have been the end of the deal. But there wasn’t. Rather than simply telling the originator that its loan pool wasn’t good enough, the investment banks would instead renegotiate the amount of money they were paying for the pool.

This is where things get positively evil. The investment banks didn’t mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren’t going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker.

In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.

Now here’s the scandal: the investors were never informed of the results of [the] test[s]. The investment banks were perfectly happy to ask for a discount on the loans when they found out how badly-underwritten the loan pool was. But they didn’t pass that discount on to investors, who were kept in the dark about that fact.

Disconcerting stuff, though judging by a recent Bloomberg poll, it wouldn’t surprise most Americans:

Wall Street financial firms and the mortgage industry get the most blame for the country’s economic weakness. More than three-quarters of the 1,000 Americans polled say the former has hurt the economy, while more than 80 percent fault the latter.

On a related note, Warren Mosler made the following observations in a recent presentation (pdf):

There is no public purpose served by allowing:

• Banks to sell their loans
• Sales of credit default risk when loans are based on credit analysis
• Banks to engage in any secondary market activity
• Proprietary trading

Mosler also observed that ”Banking should be a lot more limited than even restoring Glass-Steagall implies,” and that “The number of regulators needed increases geometrically with expanded bank activities.” He also ably dissected TARP and the shortcomings in federal stimulus measures. As he cleverly puts it on his website, “The financial sector is more trouble than it’s worth.”

And indeed, some empirical studies support the argument that the financial sector has been a mammoth rent sucking machine for decades. But good luck doing anything about it. Its immense profitability and resulting political clout have made it a powerful lobby, which is reflected in many parts of the recent Dodd-Frank legislation, as well as the deregulatory push of recent decades. And the fact is, the activities that Mosler listed have made some people incredibly wealthy, and there are simply too many more who want their shot at the million or billion dollar carrot, social consequences be damned. In fact, few if any of them even have a clue that their activities are socially harmful or neutral at best. Nothing quiets one’s conscience like visions of philanthropy, I suppose.

But despite the opaque complexities of the industry, people are on to it, as the Bloomberg poll shows. And the threat of pitch forks, however distant, might be at work in some recent industry actions, like the shutting down of proprietary trading desks and (tangentially) FINRA’s proposal to allow investors to select an all-public panel of arbitrators. Time will tell.

Astounding assertion from Hassett

Kevin Hassett must have been asleep for the past two decades.

First, in a column yesterday on sovereign debt, he argued (correctly we think) that the current rescue package for Greece is doomed:

The fatal flaw in the plan is that the European nations bailing out Greece — even Germany, where government debt has risen to about 80 percent of gross domestic product — have similar budget problems and even less political will to take similar medicine. Their plan appears to rest on the hope that lenders won’t notice. Eventually they will, and when that happens, a worldwide loss of faith in government debt markets is a virtual certainty.

But he starts heading for the deep end (emphasis added):

In other words, it is hardly good news for a creditor if a hopelessly bankrupt borrower offers to take on the debts of a hopelessly bankrupt borrower.

During the financial crisis, faith was restored in large financial institutions because toxic assets were essentially exchanged for government bonds. If government bonds become toxic, there will be no effective treatment options remaining. The collapse will have no bottom.

There are three problems here.

First, to call European governments “hopelessly bankrupt” is to simply recognize that the EMU was designed in such a way as to prevent the ECB from monetizing the debts of member nations. Some relatively simple changes to the EMU framework would prevent EMU member governments (or a supranational fiscal body) from ever becoming ”hopelessly bankrupt.” Such changes might not be high probability, but they are clearly on the minds of European leaders and policymakers.

Second, to say that there are “no effective options remaining” if all of Europe were to face default is bizarre. In a sovereign debt deflation spiral, some level of monetization, either via direct open market purchases of government debt, or unsterilized fiscal expansion, or both, is the patently obvious answer. And his convenient use of ”essentially” in describing the prior chapter in the global financial crisis allows him to leave out a critical step – money creation. And no, Cassandra, in a debt deflation spiral, monetization and fiscal expansion are unlikely to prove inflationary.

Third, to claim that a “collapse will have no bottom” is rhetorical fear mongering, devoid of any conception of natural cycles, including human ones. Every collapse has an end, by definition. In the worst case, the world’s monetary and financial systems collapse, and we end up bartering with our neighbors, friends, and families; in other words, a two century step backwards. Not pretty, but not exactly “bottomless” either. And to believe that the world’s institutions would stand by and let such a thing happen is ridiculously far fetched, better suited to a backyard-bunker novel than a business column.

He then goes off the deep end completely (emphasis added, black only):

While the U.S. has been above the fray so far, an International Monetary Fund working paper published in 2003 suggests it is hardly in safe territory…

The paper, written by economists Paolo Manasse of the University of Bologna along with Nouriel Roubini of New York University and the IMF’s Axel Schimmelpfennig, studied historical sovereign-debt crises, exactly the situations that Western nations are hoping to avoid. They found that external debt levels — money owed to foreigners — exceeding 50 percent was a key indicator that debt default may occur.

Here is the chilling fact: the average external debt as a percent of GDP among countries in their sample the year before a sovereign debt crisis was 54.7 percent, and 71.4 percent in the crisis year. The U.S. external debt on Dec. 31, 2009, was $13.77 trillion, or almost 100 percent of GDP. For much of Europe, the story is worse.

A key force driving external debt higher has been the increase in government borrowing. In its first year, the Obama administration managed to add more than $8 trillion to the expected 2019 debt, now projected to reach $17.5 trillion.

Even the optimistic scenario only delays the inevitable. Along this path, lenders continue to happily purchase government debt in the near term. But even then, the relatively healthy U.S. will look like Greece within a decade.

Our advice? Read the paper before letting Kevin get too far under your skin. The Manasse-Roubini study’s sample was composed of 54 “market access countries”, which means emerging economies with significant access to international capital markets.  Examples include Algeria, Argentina, Bolivia, Brazil, Chile, Costa Rica, Egypt, Indonesia, Jamaica, Jordan, Korea, Mexico, Morocco, Pakistan, Panama, Peru, Philippines, South Africa, Thailand, Turkey, Uruguay, and Venezuela. It was not a study of mature economies with deep and fully developed capital markets and an internationally recognized currency, e.g., the U.S., the U.K., Japan, and western Europe. Chilling??? Come on, Kev…

For Hassett to extend the study’s findings to the U.S. and other developed economies without serious qualification betrays a certain degree of historical ignorance (including Japan, whose recent history he must have slept through), or financial ignorance, which seems unlikely given his credentials, or just good old intellectual dishonesty in the service of political ends. Whichever one is at work, it reflects poorly on him.

He continues:

The only path forward is one in which the major developed nations collectively make long-run budget adjustments designed to soothe market fears before a crisis ensues. Given that the only nation serious about deficit reduction right now is Greece, it seems almost impossible for this story to reach a happy end.

Which markets is he watching, exactly? Credit spreads have been coming under increasing strain as countries have been rolling out their austerity plans. And if being “serious about deficit reduction” is a magic pill, why is Greece’s sovereign debt still the most loathed in the EMU? 

And which nations is he listening to? Spain, Portugal, and Ireland are clearly serious about deficit reduction, and Italy is signalling that it might be; and yet their credit obligations are also relatively unloved by the market. Hassett is clearly missing some part of this dynamic.

And recent flights to safety notwithstanding, the USD and Treasuries have been strengthening as deficit reduction moves towards center stage in U.S. politics. This is eerily similar to how Japanese Government Bonds and the Yen behaved from 1989 — incessantly grinding higher despite repeated warnings like the one Hassett is now making to ”the major developed nations.”

What’s happening in Europe, and to the debt of Greece and the other ‘PIIG’ nations in particular, is being driven by the combination of an undeveloped fiscal structure for the EMU and strict constraints on the ECB’s open market activities. Yes, Greece’s prior government screwed up royally (apparently with some help from our sacred financial sector) and needs to make adjustments and amends to its fellow EMU members. But certain aspects of the crisis are also related to national policies and the EMU’s institutional framework that are depressing total output in much of the EU — in other words, there are amends aplenty to go around. And most importantly, hairshirt economics are not likely to improve the situation.

Hassett concludes:

Our choice is panic now, or panic later.

Clearly, Hassett is choosing panic now. And the last people you want by your side in a crisis — much less making decisions — are the panicky types.

URLs:

http://preview.bloomberg.com/news/2010-05-17/greece-s-bailout-heroes-arrive-in-leaky-boats-commentary-by-kevin-hassett.html

http://www.businessweek.com/news/2010-05-17/eu-faces-trichet-s-quantum-leap-call-as-euro-falls-update2-.html

http://www1.voanews.com/english/news/europe/Greek-PM-Considers-Legal-Action-Against-US-Banks-93885419.html

http://www.timesonline.co.uk/tol/news/world/us_and_americas/article6907681.ece

SEC’s Goldman bombshell

The SEC has filed a civil complaint against Goldman Sachs alleging fraud (yes, the f-word) for synthesizing an asset backed security related to residential mortgage loans in 2007. It was done for one of Goldman’s prize clients — John Paulson’s hedge fund, which returned billions of dollars to partners as the wave of mortgages security downgrades and defaults broke (and according to some authors, alerted Goldman to looming problems in mortgage markets) – so that he could take a large short position in (i.e., sell) U.S. mortgage securities.

The rub is that every short seller requires a buyer. And the SEC complaint alleges that Goldman’s and others’ disclosures to buyers were not above board.

There are many, many angles to this story — reputational risk, the firm’s culture and political capital, effects on pending financial regulation, implications for other investment banks and certain hedge funds — the list goes on. We think there are two quick takeaways worth thinking about:

First, the episode illuminates the dark side of financial innovation. There are actually grounds in financial theory for defending creation of this type of product. But it’s apparent that such innovations create serious agency risks for the parties involved. And the SEC is alleging that Goldman did not manage those risks effectively.

Second, we can use the event to cast a different light on the idea of “too big to fail.” At least in this case, the problem appears to have been that Goldman was too big to conduct itself ethically. We’ll leave it to readers to debate whether  “greedy” should be substituted for “big”. In the meantime, the market has been vomiting Goldman shares since the news broke.

URLs:

http://sec.gov/news/press/2010/2010-59.htm

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. At the time of this writing, neither the firm nor its clients own shares of stock or any securities issued by Goldman Sachs. One of the firm’s principals owns shares of Goldman Sachs common stock. 

Good column by Ron Rhoades

 Good column by Ron Rhoades on RIABiz.com, in which he predicts what types of financial reforms might come out of Congress in the current session. He echoes some concerns we’ve raised (emphasis added):

There are many parts of the overall financial services reform legislation that are incremental improvements over what we have today, and which should be supported. I hope the upcoming amendments will address “too big to fail” and reduce the perverse compensation incentives which tend to drive improper risk-taking activities.

I am deeply troubled, however, by the lack of oversight of all credit default swaps and other forms of derivatives. There are likely to remain many gaps in regulation which can continue to be exploited.

Additionally, much of the bill appears to fragment, rather than to consolidate, banking regulation. Regulation needs to be robust – to paraphrase James Madison, if securities industry participants were all angels, regulation would not be needed. But regulation also needs to be efficient. Our country cannot afford inefficient regulation of the same functional areas through duplicative, often over-lapping agencies.

This point, on disclosure as panacea, was particularly interesting, and lends some support to our call (and others’) for bringing basic financial education (legal might be a good idea too) into primary education:

The fundamental problem is that the SEC continues to emphasize disclosure above all else. While I support better disclosures of compensation practices and conflicts of interest, we must be realistic in what disclosure can accomplish. Disclosures are usually ineffective, as research into behavioral biases has demonstrated.

Today the financial world is far more complex for consumers than it was in 1940. Hence, disclosures utterly fail to overcome the huge “knowledge gap” between financial advisors and their clients.

The full column is available here: http://www.riabiz.com/a/748005?subscribed=true

Crisis, regulation, vigilance & cynicism

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.”

Koppenheffer continues:

…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. 

I suppose we’re a bit cynical too.  

URLs:

http://www.fool.com/investing/general/2010/03/24/why-the-fed-will-fail.aspx

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1553816

http://en.wikipedia.org/wiki/Internet_vigilantism

http://en.wikipedia.org/wiki/Harry_Markopolos

Another banner day in the finance industry

Six broker dealers are served subpoenas by Massachusetts securities regulators over private placements, and a former high flyer is reportedly shut down by FINRA.

URLs:

http://www.investmentnews.com/article/20100322/FREE/100329978/-1/INDaily01

http://www.investmentnews.com/article/20100322/FREE/100329997

Hamilton: Credit crisis causes vs symptoms

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.

URLs:

http://www.econbrowser.com/archives/2010/03/modeling_proble.html

http://www.newyorker.com/reporting/2008/12/01/081201fa_fact_cassidy?currentPage=all

Smart Money: Credit Card Companies

Smart Money magazine has a great long running feature, “Ten Things.” Their latest is “Ten Things Your Credit Card Company Won’t Tell You,” a rather timely dissection given passage of the CARD Act.

URLs:

http://www.smartmoney.com/spending/rip-offs/10-things-your-credit-card-company-wont-tell-you-18808/?cid=1230

Stiglitz: The Dangers of Deficit Reduction

A timely column from Nobel economist Joe Stiglitz (emphasis added):

A wave of fiscal austerity is rushing over Europe and America…But despite protests by the yesterday’s proponents of deregulation, who would like the government to remain passive, most economists believe that government spending has made a difference, helping to avert another Great Depression.

…even deficit hawks acknowledge that we should be focusing not on today’s deficit, but on the long-term national debt. Spending, especially on investments in education, technology, and infrastructure, can actually lead to lower long-term deficits. Banks’ short-sightedness helped create the crisis; we cannot let government short-sightedness – prodded by the financial sector – prolong it.

Faster growth and returns on public investment yield higher tax revenues, and a 5 to 6% return is more than enough to offset temporary increases in the national debt. A social cost-benefit analysis (taking into account impacts other than on the budget) makes such expenditures, even when debt-financed, even more attractive.

In those last two paragraphs, Stiglitz is pointing out that if the returns on public spending are greater than the cost of financing them, then the future debt level will actually be lower. The government’s current cost of financing is simply the yield on Treasury debt. As of Friday, the ten year Treasury note yields 3.7%, while thirty year Treasury bonds yield about 4.6%. If publicly financed investments can be expected to return more than those figures, then undertaking them — and adding to current deficits and debt levels — is a no-brainer.

And as long as the yields on the securities of private sector issuers aren’t abnormally higher than those on Treasuries, the argument that the federal government is going to ‘crowd out’ the private sector is without merit.

Of course, it’s debatable (1) whether public expenditures are likely to produce returns of that magnitude and (2) whether future Congresses, Administrations, and Treasury Departments will manage the federal balance sheet appropriately. Unfortunately, no one’s openly debating these points. Instead, we’re treated to pithy but nonstop dogma from both sides, and a peculiar obfuscation by those in the middle, which in all cases overlook the basic financial calculus that Stiglitz reminds us of in his column.

Most importantly for debt and deficit hawks and those who fear higher taxes (those whom econo-nerds would refer to as ‘Ricardian equivalence’ subscribers), when the financial calculus is positive, then the debt service associated with marginal federal spending can be financed organically, via higher growth, rather than through higher taxes.

In short, people on all sides of the deficit issue should be able to agree, at least on financial and economic grounds, that investments yielding more than their cost of financing, when they do not crowd out private sector borrowing or resource demand, should absolutely be carried out.

—

Unfortunately, Stiglitz overlooks his own argument when he writes the following, which make us wonder if he doubts his 5 to 6% return figures, or if he’s just offering a gratuitous slap at the financial sector (emphasis added):

As the global economy returns to growth, governments should, of course, have plans on the drawing board to raise taxes and cut expenditures…

Continuing with his love of taxes:

The financial sector has imposed huge externalities on the rest of society. America’s financial industry polluted the world with toxic mortgages, and, in line with the well established “polluter pays” principle, taxes should be imposed on it. Besides, well-designed taxes on the financial sector might help alleviate problems caused by excessive leverage and banks that are too big to fail. Taxes on speculative activity might encourage banks to focus greater attention on performing their key societal role of providing credit.

As we’ve pointed out elsewhere, the domestic financial sector is going to shrink even without  punitive measures, as demographic composition shifts away from the saving and investing age groups. Well-designed regulation might be a better approach than taxes to constraining financial sector activities to socially beneficial ones (we admit that a ‘Tobin tax’ can be the most efficient approach to regulation under certain conditions, but aren’t convinced that it’s optimal for the financial sector).

And it would be profoundly unjust for the federal government, which so strongly encouraged and underwrote the expansion of mortgage financing (Stiglitz’ “pollution”), to retroactively punish the financial sector, its employees, and its current and future clients for simply following the government’s orders.

Stiglitz also takes a step back from his underlying thesis with this sentence:

Over the longer term, most economists agree that governments, especially in advanced industrial countries with aging populations, should be concerned about the sustainability of their policies.

From a technical standpoint, this isn’t as iron clad as so many of us reflexively believe. First, we have no idea whether an aging population is bound to be a drag on an economy, whether it depends on particular conditions, or anything else. There simply isn’t much historical data available to test such a proposition. Second, if we assume that it is a significant drag, then policies that are seen as unsustainable under “normal” conditions might very well be the most sustainable under those novel conditions. This could include expanded deficit spending and public debt, and/or expansion of money supply.

[To be fair, Stiglitz is almost certainly referring to entitlement spending obligations in that passage, which might be a bird of a different feather. We're just using it as an opportunity to critique some of the conventional wisdom around demographics.]

—

Despite Sitglitz’ inability to break out of his New Keynesian box, or part ways with his passion for higher taxes, we agree wholeheartedly with his essential argument:

…even with large deficits, economic growth in the US and Europe is anemic, and forecasts of private-sector growth suggest that in the absence of continued government support, there is risk of continued stagnation – of growth too weak to return unemployment to normal levels anytime soon.

The risks are asymmetric: if these forecasts are wrong, and there is a more robust recovery, then, of course, expenditures can be cut back and/or taxes increased. But if these forecasts are right, then a premature “exit” from deficit spending risks pushing the economy back into recession. This is one of the lessons we should have learned from America’s experience in the Great Depression; it is also one of the lessons to emerge from Japan’s experience in the late 1990’s.

…we must be wary of deficit fetishism…high-return public investments that more than pay for themselves can actually improve the well-being of future generations, and it would be doubly foolish to burden them with debts from unproductive spending and then cut back on productive investments.

These are questions for a later day – at least in many countries, prospects of a robust recovery are, at best, a year or two away. For now, the economics is clear: reducing government spending is a risk not worth taking. 

URLs:

http://www.project-syndicate.org/commentary/stiglitz123/English

http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

Masters of the Universe: They’re baaaack…

A new BIS paper has some very telling data points. First, they demonstrate the extent to which leveraged financial speculation drove foreign currency movements in the financial crisis (it’s quite reasonable to assume that this factor was at work in other asset class dislocations too). Second, it provides evidence that highly leveraged masters of the universe were back to their old tricks in fairly short order.

Let’s start with a  quick primer on “carry trades.”  A carry trade occurs when a financial market participant borrows in some currency with a low nominal interest rate (the “funding currency”) and invests the loan proceeds in some asset(s) (a “target asset”) that’s expected to appreciate at a rate that exceeds the interest rate due on the borrowed currency. The target asset can be a higher yielding currency, a credit instrument, equities or a stock market proxy, commodities or a commodity index proxy, and so on.

The Yen carry trade — borrowing low yielding Japanese Yen and using them to acquire riskier assets – has been increasingly employed by speculators since the 1990s, and appears to have played a key role in the speculative period of 2004-2008.

Speculators engaging in this activity are taking risks (sometimes massive risks) with (for the most part) Other People’s Money (OPM). When it works, they return the borrowed funding currency plus interest, and pocket the difference. When it goes terribly wrong, you wind down operations and hide from your creditors behind a corporate liability shield, forcing them to write down the value of their loans to you (their funding currency assets).

Nice work if you can get it, and amazingly, investment banks and their subsidiaries have been falling all over themselves to make these loans to privileged clients — including their own proprietary desks and funds — since the late 1990s (in competitive strategy, herd pursuit of bad ideas is usually a sign of an over crowded industry).

Better yet for the carry traders, increasingly lax financial regulation has allowed speculators to lever their carry up to levels not seen before in modern history, meaning they can borrow more money for a given level of collateral, and/or purchase more assets with a given amount of funding currency.

As some of those trades started to go bad in 2008, the result was a breathtakingly sharp and sudden reversal in the key funding currency, the Yen. This can be seen in the circled graph below, along with the following observations:

• The rate of appreciation in the Yen was far greater in 2008 than in the 1997 and 1998 global financial crises. The left most graph shows foreign exchange movements between the Yen and thirty three other currencies during the Asian crisis of 1997. Clearly, forex movements in that crisis were country specific.
• The middle graph shows currency movements against the Yen during the 1998 crisis associated with the Russian sovereign debt default. The appearance of a positive slope is apparent, implying that forex dislocations were due more to speculative behaviors including the rising use of leverage than to country-specific risks (for that we can probably thank the pioneering geniuses at LTCM and their investment bank benefactors).
• The third graph shows the appreciation of the Yen during the recent global financial crisis. The slope, which gives an idea of how sharply the Yen appreciated against those 33 other currencies, is breathtaking. The median interest rate on the target currencies (on the horizontal axis) also appears to have been roughly half of what it was in 1998.

Translating into English, this means that in 2008-09, the Yen appreciated even more sharply than it did in 1998, and against target assets that offered half the expected return of those in 1998. This calls to mind a question we raised recently, which is whether some powerful financial market participants are confusing ”efficient dislocation” with “market efficiency.” That would be understandable after all. History shows that the fatter the economic rents being justified, the more deluded the economic rationales tend to be.

In the BIS paper, the author also notes that carry trade activities are inherently pro-cyclical: borrowing activity tends to push down the market value of the funding currency, while investing activity tends to push up the market value of the target assets, and this will tend to invite increasing levels of speculation until something causes a breakdown.

Higher degrees of leverage make the pro-cyclicality and the eventual fallout that much worse. Unfortunately, while a great deal has been made of John Maynard Keynes’ alleged return in the past year, it appears that the brief 2008-09 resurgence of Hyman Minsky — who warned presciently of such dangers – has already been forgotten.

That “Minsky fade” appears to be supported by the bottom right graph (though admittedly, this case isn’t as strong as the leveraged carry trade evidence discussed above). The negative slope in that graph shows that less than a year later, the Yen depreciated markedly against many currencies, especially against higher yielding target currencies, which runs counter to the aftermath of 1997 and 1998.

The implication is that the Yen carry trade came back on line fairly quickly after financial markets regained their footing. Apparently financial cockroaches are, like their arachnid namesakes, largely immune to the effects of fallout. As described by the BIS author:

…with extreme risk aversion abating, carry trade activity – a relatively risky strategy – may have returned in the second half of 2009. Indeed, carry trades in a number of high-yielding currencies, especially those of commodity exporters, provided extraordinarily high ex post returns over this period. Moreover, near zero interest rates prevailed in many major currencies, increasing ex ante profitability not only for traditional funding currencies such as the yen. Carry-to-risk ratios support this conclusion…

A a critically important aspect of this issue is financial regulatory reform. Very little has been done from a regulatory standpoint to bring down the astronomical leverage that was available for carry trade speculation prior to 2008. Yesterday, Larry Summers gave an interview to CNBC in which he emphasized that the scope of the proposed “Volcker Rule” was limited to particular types of banks.

If true, over leveraged areas of global financial markets are likely to continue escaping prudent regulation, which means that the pronounced cycles of euphoria and distress in risky asset classes will continue. While those swings create opportunities for contrarian investors, the dynamic behind them is a zero-sum or even net-negative economic game. In the long run, it causes more economic harm than it’s worth.

And while interest rates have converged substantially since the 1990s, current spreads are likely to persist in the decade ahead for multiple reasons, not least being variation in demographic cycles, which will mean lower nominal rates in most developed countries, and higher rates in most emerging markets.

In other words, the roach bait isn’t going anywhere soon. That means that sound regulation absolutely must fill the void in order for the gains from financial market speculation to approach something resembling a social optimum.

UPDATE 3/2/2010 – AP report on further progress in Senate Finance on financial regulation

URLs:

http://www.bis.org/publ/qtrpdf/r_qt1003f.pdf?noframes=1

http://654advisors.com/index.php/blog/2010/02/wsj-hedge-fund-career-trades/

http://news.yahoo.com/s/ap/20100302/ap_on_bi_ge/us_financial_overhaul