Monthly Archive for March, 2009

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Money creation and the Fed

Published on 3/29/2009 in Financial Crisis . Closed

Jim Hamilton gets deep into the Fed’s innovations. Among the best analysis I’ve seen — containing some gems like this:

…Where did the Fed get the resources to do all this? In part, it asked the Treasury to borrow on its behalf, represented by the pale yellow region in Figure 7 below, and a sum that last week amounted to a quarter trillion dollars. Note that magnitude is not part of the monetary base drawn in Figure 1. Some of the Fed expansion has shown up as additional currency held by the public, which made a modest contribution to the explosion of the monetary base seen in Figure 1. But by far the biggest factor was a 100-fold increase in excess reserves, the green region in Figure 7. These excess reserves mean that for the most part, banks are just sitting on the newly created reserve deposits, holding these funds idle at the end of each day rather than trying to invest them anywhere.

Figure 7. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

That idleness, as I read the situation, was something the Fed initially actually wanted, and deliberately cultivated by choosing to pay an interest rate on excess reserves that is equal to what banks could expect to obtain by lending them overnight. As long as banks do just sit on these excess reserves, the Fed has found close to a trillion dollars it can use for the various targeted programs.

But what would happen if those electronic credits start to be redeemed for actual cash? Then we would have a concern, and the Fed would need to call the reserves back in by selling assets or failing to renew loans. But that presents a potential problem, as noted by Charles Plosser, President of the Federal Reserve Bank of Philadelphia:

Continue reading…

The Stimulus Package Considered against a Deteriorating Macro Backdrop

Published on 3/29/2009 in Financial Crisis . Closed

Menzie Chin has some hair curling charts and commentary – his point being that the huge “stimulus” plan may not be so huge in the context of the meltdown.

Here are the latest CBO forecasts of the output gap and unemployment rate, as well as counterfactual gap and rate that would have taken place in the absence of the stimulus package.

[From The Stimulus Package Considered against a Deteriorating Macro Backdrop]

I agree with Chin’s magnitude thesis. I still think the HR1 bill was typical Congressional sausage — late, poorly targeted, horribly inefficient.

New Home Sales: Is this the bottom?

Published on 3/29/2009 in Financial Crisis . Closed

The best source I know for accurate perspective on housing is Calculated RIsk. This post is a good resource for examining how we might recognize the housing bottom. Follow the links to the supporting data.

Earlier today I posted some graphs of new home sales, inventory and months of supply.

A few key points:

  • Please do not confuse a bottom in new home sales with a bottom in existing home prices. Please see: Housing: Two Bottoms
  • New home sales numbers are heavily revised and there is a large margin of error. Regarding the sales for February, the Census Bureau reported:

    This is 4.7 percent (±18.3%) above the revised January rate of 322,000, but is 41.1 percent (±7.9%) below the February 2008 estimate of 572,000.

  • The “rebound” in February was very small, and this is the worst February since the Census Bureau started tracking new home sales in 1963.

    New Home Sales and Recessions Click on graph for larger image in new window.

    This graph shows the February “rebound”.

    You have to look closely – this is an eyesight test – and you will see the increase in sales (if you expand the graph).

    Not only was this the worst February in the Census Bureau records, but this was the 2nd worst month ever on a seasonally adjusted annual rate basis (only January was worse).

  • Still, I believe there is a good chance new home sales will bottom in 2009. See Looking for the Sun. Because the data is heavily revised, we won’t know until many months after the bottom occurs. Also, as Dr. Yellen noted earlier, we need to distinguish between growth rates and levels. Any bottom would be at a very grim level, and any recovery would probably be very sluggish because of the huge overhang of existing homes (especially distressed homes). It is theoretically possible for new home sales to go to zero (very unlikely), and it is also possible that January was the bottom. We just don’t know …
  • <snip>
  • Finally, even though some signs of a bottom might emerge (housing starts, new home sales, auto sales), it is worth repeating that any recovery will probably be very sluggish. Here are a few key reasons: house prices are still too high, there is too much housing inventory (especially distressed properties), households have too much debt and need to improve their balance sheets, the recession is global, and the Obama administration has chosen a less than optimal (and very expensive) approach to fixing the financial system.

From a related post, CR shows the latest new home months of inventory, currently at 12.2 months compared to normal of 6 to 8 months.

New Home Months of Supply and RecessionsThere were 12.2 months of supply in February – just below the al time record of 12.9 months of supply set in January.

On March 23, Calculated Risk summarized what to look for:

I think the keys to watch for the housing market are declining inventory levels, a bottom in new home sales, and the gap between new and existing home sales closing.

Experimental economics: you get bubbles and crashes

Published on 3/28/2009 in Economics . Closed

This is not what I was taught in undergraduate economics — but experimental economics offers conclusive evidence of a core flaw in the efficient market hypothesis. Here’s a recent Atlantic summary of some of the research:

…Before financially sophisticated readers drag out their calculators, look up interest rates, and compute the present value of those future payments, I have a confession to make. You can’t buy this security, and it doesn’t really pay dividends every four weeks. It pays every four minutes, in a computer lab, to volunteers in economic experiments.

For more than two decades, economists have been running versions of the same experiment. They take a bunch of volunteers, usually undergraduates but sometimes businesspeople or graduate students; divide them into experimental groups of roughly a dozen; give each person money and shares to trade with; and pay dividends of 24 cents at the end of each of 15 rounds, each lasting a few minutes. (Sometimes the 24 cents is a flat amount; more often there’s an equal chance of getting 0, 8, 28, or 60 cents, which averages out to 24 cents.) All participants are given the same information, but they can’t talk to one another and they interact only through their trading screens. Then the researchers watch what happens, repeating the same experiment with different small groups to get a larger picture.

The great thing about a laboratory experiment is that you can control the environment. Wall Street securities carry uncertainties—more, lately, than many people expected—but this experimental security is a sure thing. “The fundamental value is unambiguously defined,” says the economist Charles Noussair, a professor at Tilburg University, in the Netherlands, who has run many of these experiments. “It’s the expected value of the future dividend stream at any given time”: 15 times 24 cents, or $3.60 at the end of the first round; 14 times 24 cents, or $3.36 at the end of the second; $3.12 at the end of the third; and so on down to zero. Participants don’t even have to do the math. They can see the total expected dividends on their computer screens.

Here, finally, is a security with security—no doubt about its true value, no hidden risks, no crazy ups and downs, no bubbles and panics. The trading price should stick close to the expected value.

At least that’s what economists would have thought before Vernon Smith, who won a 2002 Nobel Prize for developing experimental economics, first ran the test in the mid-1980s. But that’s not what happens. Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the 15th round nears, it crashes. The problem doesn’t seem to be that participants are bored and fooling around. The difference between a good trading performance and a bad one is about $80 for a three-hour session, enough to motivate cash-strapped students to do their best. Besides, Noussair emphasizes, “you don’t just get random noise. You get bubbles and crashes.” Ninety percent of the time.

So much for security.

These lab results should give pause not only to people who believe in efficient markets, but also to those who think we can banish bubbles simply by curbing corruption and imposing more regulation. Asset markets, it seems, suffer from irrepressible effervescence. Bubbles happen, even in the most controlled conditions.

[...]

But people do learn. By the third time the same group goes through a 15-round market, the bubble usually disappears. Everybody knows what the security is worth and realizes that everybody else knows the same thing. Or at least that’s what economists assumed was happening. But work that Noussair and his co-authors published in the December 2007 American Economic Review suggests that traders don’t reason that way.

[...]

For those of us who invest our money outside the lab, this research carries two implications.

First, beware of markets with too much cash chasing too few good deals. When the Federal Reserve cuts interest rates, it effectively frees up more cash to buy financial instruments. When lenders lower down-payment requirements, they do the same for the housing market. All that cash encourages investment mistakes.

Second, big changes can turn even experienced traders into ignorant novices. Those changes could be the rise of new industries like the dot-coms of the 1990s or new derivative securities created by slicing up and repackaging mortgages. I asked the Caltech economist Charles Plott, one of the pioneers of experimental economics, whether the recent financial crisis might have come from this kind of inexperience. “I think that’s a good thesis,” he said. With so many new instruments, “it could be that the inexperienced heads are not people but the organizations themselves. The organizations haven’t learned how to deal with the risk or identify the risk or understand the risk.”

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Bonds vs. stocks – Part 2 by John Mauldin

Published on 3/28/2009 in Financial Crisis . Closed

John Mauldin has an extended discussion of the new Rob Arnott paper “Bonds: Why Bother?” in the upcoming Journal of Indexes.

Dollar in trouble?

Published on 3/28/2009 in Financial Crisis . 1 Comment

US Treasury Secretary Tim Geithner shocked global markets by revealing that Washington is “quite open” to Chinese proposals for the gradual development of a global reserve currency run by the International Monetary Fund.

Are the dollar’s days numbered?

The dollar plunged instantly against the euro, yen, and sterling as the comments flashed across trading screens. David Bloom, currency chief at HSBC, said the apparent policy shift amounts to an earthquake in geo-finance.

“The mere fact that the US Treasury Secretary is even entertaining thoughts that the dollar may cease being the anchor of the global monetary system has caused consternation,” he said.

Mr Geithner later qualified his remarks, insisting that the dollar would remain the “world’s dominant reserve currency … for a long period of time” but the seeds of doubt have been sown.

The markets appear baffled by the confused statements emanating from Washington. President Barack Obama told a new conference hours earlier that there was no threat to the reserve status of the dollar.

“I don’t believe that there is a need for a global currency. The reason the dollar is strong right now is because investors consider the United States the strongest economy in the world with the most stable political system in the world,” he said.

The Chinese proposal, outlined this week by central bank governor Zhou Xiaochuan, calls for a “super-sovereign reserve currency” under IMF management, turning the Fund into a sort of world central bank.

The idea is that the IMF should activate its dormant powers to issue Special Drawing Rights. These SDRs would expand their role over time, becoming a “widely-accepted means of payments”.

Mr Bloom said that any switch towards use of SDRs has direct implications for the currency markets. At the moment, 65pc of the world’s $6.8 trillion stash of foreign reserves is held in dollars. But the dollar makes up just 42pc of the basket weighting of SDRs. So any SDR purchase under current rules must favour the euro, yen and sterling.

Beijing has the backing of Russia and a clutch of emerging powers in Asia and Latin America. Economists have toyed with such schemes before but the issue has vaulted to the top of the political agenda as creditor states around the world takes fright at the extreme measures now being adopted by the Federal Reserve, especially the decision to buy US government debt directly with printed money.

Mr Bloom said the US is discovering that the sensitivities of creditors cannot be ignored. “China holds almost 30pc of the world’s entire reserves. What they say matters,” he said.

Mr Geithner’s friendly comments about the SDR plan seem intended to soothe Chinese feelings after a spat in January over alleged currency manipulation by Beijing, but he will now have to explain his own categorical assurance to Congress on Tuesday that he would not countenance any moves towards a world currency.

Michael Santoli on bonds vs. stocks

Published on 3/28/2009 in Financial Crisis . Closed

A couple of excerpts from Barron’s Streetwise column (HT: Barry Ritholz). Unfortunately, Santolio doesn’t even mention the comparison of risk-adjusted returns (e.g., Sharpe Ratio or Sortino Ratio).

As a result, once again (nominally) high-grade corporate bonds are looking rather attractive by several measures.

J.P. Morgan Chase credit analyst Eric Beinstein last week noted that the high-grade bond benchmark is pricing in “a default rate of about 45%” over the next 10 years — and 10 years is the average life of the bonds in the index. He says this means a hypothetical investor could buy the components of the index, funding the purchase at the London Interbank Offered Rate, watch 45% of the bonds go bust, then recover only 20% of face value, and still break even for the decade.

The worst 10-year default rate for high-grade debt since 1980, he says, was 5%, implying the market is building in truly cataclysmic credit losses, in part because liquidity in this market remains so scarce.

This is an extended way of illustrating that — outside the ultra-high-quality slice of the market — corporate debt now should reward prudent risk-taking.

It remains the case that the conditions that would boost the value of corporate debt should also be equity-friendly. But as we have seen repeatedly, the relationship between moves in these two markets are neither synchronous nor predictable.

A new research paper, however, urges investors to beware of that assumption, because stocks can trail bonds for very long stretches, as was the case in the market rout that began in October 2007. “The widely accepted notion of a reliable 5% equity risk premium is a myth,” contends Robert Arnott, chairman of money manager Research Affiliates, in a paper to be published this spring in The Journal of Indexes.

“We’ve had 30 to 40 years of building this cult of equities, where if your time horizon is long enough, it doesn’t matter what you pay for stocks,” Arnott tells Barron’s. “That’s dangerous.”

It’s especially dangerous for investors, from individuals to endowment to pension funds, who were counting on equities to outrun fixed-income holdings and deliver supersized returns.

From 1802 to 2008, Arnott says, stocks outpaced bonds by 2.5 percentage points annually. But that superior showing can be deceiving because there were long stretches in which stocks underperformed, most recently in the 41-year period that ended on Feb. 28. True, the Standard & Poor’s 500 lagged behind the 20-year Treasury bond by a mere two basis points (two hundredths of a percentage point) a year in this lengthy span, but that’s enough to render it a substandard performer.

Bonds also beat stocks from 1803 to 1871, and from 1929 to 1949. But there were other multi-decade spans, such as the period from 1932 to 2000, when “stocks beat bonds reasonably relentlessly,” Arnott says.

On balance, he writes, stocks have had “long periods of disappointment, interrupted by some wonderful gains.”

Stocks hold appeal at currently depressed levels, Arnott contends, noting that the S&P looks a lot more attractive today, with a dividend yield around 3.4%, than it did when its yield was much lower — and its price/earnings multiple much loftier. “Price matters,” he says. “What you pay has a lot to do with what you are going to earn. If there’s a 4% dividend yield, you can have a lot more confidence that you are going to have a decent return than if your yield is 1%.”

Jeremy Siegel, a Wharton professor whose books include Stocks For the Long Run, counters that stocks are getting a bad rap. “What I find interesting is that researchers cite the poor equity returns of the past 10 or 20 years as evidence that you should not hold stocks in the future,” Siegel wrote in an e-mail. “On the contrary, the worse stocks have done in the past, the better they are now.”

He points out that “the worst backward-looking stock returns were in July 1932 [and] yet that was the single best time to buy stocks ever, [as they outpaced] ALL other assets over the next five, 10, and 20 years.” History just might repeat.

Dubai's rotating skyscraper

Published on 3/28/2009 in Technology . 4 Comments

Innovation happens — of course Dubai-sized budgets help a LOT. Architect David Fisher’s design is certainly “outside the box thinking”. The video animation will give you a hint of how the super-rich might live there.

Dr. David Fisher’s Dynamic Tower is the first building in motion that will change its shape and add a fourth dimension to architecture: Time. The shape will be determined by each floor’s direction of rotation, speed, acceleration and the timing; with timing meaning how each floor rotates compared to the other. The rotation speed will be between 60 minutes and 24 hours for one revolution.

Residents, if they own the entire floor, are able to control the speed and direction of the rotation by voice command. One can have breakfast watching the sunrise, lunch viewing the open sea, and dinner overlooking the lights of the city – all from the same place inside their unit. The other floors will be commanded by the architect, by the mayor or whoever will have the password to the computer program that will give the building a different shape at every glance.

The building is designed to be factory built then self-erected via the central core.

Dr. David Fisher’s revolutionary Dynamic Tower, the first building in motion, is the first skyscraper to be entirely assembled in a factory from pre-fabricated parts. The factory-made construction process offers many of the advantages of any modern industrial product: conserving energy, reducing construction time and dramatically cutting costs. Each individual unit is completely finished at the Factory and exported worldwide to the assembly site , ready for quick and efficient installation.

Each module of each unit is fully equipped with all necessary plumbing and electric systems plus all finishes from floor to ceiling, customized according to the owners’ specifications, including bathrooms, kitchens, lighting and even furniture. The pre-fabricated module units are then simply hooked together mechanically and hoisted up the concrete core, completed from the top down. Due to their pre-fabrication, these buildings of the future will also be easy to maintain and repair, making them more durable than any traditional structure.

Dr. Fisher states, “Almost every product used today is the result of an industrial process and can be transported around the world, from cars and boats to computers and clothing. Factories are utilized due to their ease of access to raw materials, integrated production technologies, and efficient labor processes, which result in high quality at a relatively low er cost.” Dr. Fisher continues, “It is unbelievable that real estate and construction, which is the leading sector of the world economy, is also the most primitive. For example, most workers throughout the world still regularly use trowels that were first used by the Egyptians and then by the Romans. Buildings should not be different than any other product, and from now on they will be manufactured in a production facility.”

But there might be a few problems:

WCBStv.com: Fisher acknowledges that he is not well known, has never built a skyscraper before and hasn’t practiced architecture regularly in decades. But he insisted his lack of experience wouldn’t stop him from completing the project, which has attracted top design talent, including Leslie E. Robertson, the structural engineer for the World Trade Center and the Shanghai World Financial Center.

“I did not design skyscrapers, but I feel ready to do so,” Fisher said.

Chart of the Day: The CDS-Bond Basis

Published on 3/28/2009 in Financial Crisis . Closed

Felix Salmon

Many thanks to JP Morgan, which sent me the data for the above chart, which shows the CDS-bond basis for BBB-rated debt. In English, that means it’s the number you get when you take the CDS spread on BBB-rated credits (that’s the lowest investment-grade rating), and subtract the yield on those credits’ bonds.

The lower this number goes, the higher the arbitrage opportunity: you can buy a bond, hedge it with a CDS, and pocket the profits.

It’s not a perfect hedge, since there are counterparty risks involved, but they’re normally dealt with through margining requirements. Was the plunge in the CDS basis between September and December the result of a huge increase in counterparty risk? It’s possible: it’ll be very interesting to see what happens to the basis if and when these credits migrate to a CDS exchange with minimal counterparty risk.

It’s also far from clear whether the above chart is what was responsible for a large part of Merrill Lynch’s $15 billion in fourth-quarter losses. But remember that historically the basis has been positive, which means that Merrill’s traders might well have seen a juicy profit opportunity when the basis turned negative in 2008. After all, what were the chances it would get much worse?

Flaws of the ABX indices

Published on 3/28/2009 in Financial Crisis . Closed

Felix Salmon

…on the subject of the notorious ABX subprime indices. We’ve been here before, many times, but no one ever seems to learn: the ABX indices do not measure bond prices. They do not give an indication of what subprime-backed bonds are worth in terms of cents on the dollar. If the triple-A ABX index is at 79, that does not mean that AAA tranches of CDO trade at, or are worth, 79 cents on the dollar.

What’s more, the ABX tranches always refer to the weakest tranche of any given bond. They are also much less liquid than you might think: Alea provides the bid-ask spreads, which are a minimum of 8 points on the most recent series. (Interestingly, the older, “off-the-run” series seem to be more liquid, weirdly enough.)

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