Entries in systemic risk (23)


Cochrane on Tucker and Bagehot at Hoover

A must read, probably one of the most important pieces we've seen recently on financial regulation & systemic risk.  It is concise & easy to understand and has links to all the good stuff.

Tucker and Bagehot at Hoover





Mutual funds or mutual fund companies as Systemically Important Financial Institutions (SIFI)

We strongly recommend all read Bill McNabb's piece in today's Wall Street Journal. He is the CEO of Vanguard.

Regulators prepare to declare that large funds pose a ‘systemic’ financial risk. Investors will pay the price


This is an important issue: the proposed regulations are hugely destructive to the US capital markets and investors alike. Unlike the assets of banks, mutual funds have no maturity, hence no roll-over risk therefore no risk of default. They merely have price which reflects supply and demand.

At base we can extend the terribly flawed notions implicit in this regulation: equity investors now will be the lender of last resort to (or you may read that as "owners without voting rights" of) the TBTF banks. 

Of course, consider the preferred, but politically unavailable solution (at least for now) these regulators really want: the ability to prohibit sales of mutual funds whenever the Fed so macro-prudentially deems it appropriate. We jest? The institutional money market funds already have gating mechanisms, and they are now trying to push them in a slightly different form to the equity markets.

And we haven't even mentioned the costs which present yet another taking, a confiscation & transfer, of property rights & wealth to the regulatory state.


On mythology: Q1 2015 review & outlook

Updated on Friday, April 10, 2015 at 07:47AM by Registered Commenterhb

Our fundamental outlook has not changed from last quarter’s review, and we think we got the broader mechanics right. We actually suggest readers go back and read the first five paragraphs. These are long lived themes, and we’re going to be multiplying and extending some of them.

What is new, or slightly different, is that the pressures are building, some accelerating, and there seems to be increasing recognition by the markets and electorate that something is amiss.

Click to read more ...


Q4 Review & Outlook for 2015 

Updated on Thursday, January 15, 2015 at 08:37AM by Registered Commenterhb

Updated on Thursday, January 15, 2015 at 08:42AM by Registered Commenterhb

Our intermediate term outlook is shaped by the sense that ill conceived macro policies - fiscal, monetary, tax, regulatory & social - have done large scale damage to essential components of the US economy and that recovery of the wealth creation process will be slow & increasingly risky.

Click to read more ...


Volatility: the inverse bubble

Updated on Wednesday, June 18, 2014 at 01:34PM by Registered Commenterhb

We were dismayed to see today’s WSJ article Fed Officials Growing Wary of Market Complacency only because we were working on the final draft of this posting yesterday. No matter.  We recommend the better and earlier article of May 20th,  Tranquil markets are enjoying too much of a good thing by Ms. Trett of the FT about the continuing decline of volatility in nearly every market. It is worrisome, and we’re not sure anyone understands why it is happening. Nor is it limited to equity markets: oil, fixed income, currencies... pick a card.

Click to read more ...


The taper of Q3: actual results may vary


Now you see me, now you don't. Now you see me, soon you won't!


The country seems to be facing a crisis of confidence that now surpasses that of Jimmy Carter’s “malaise”. There is a loss of confidence in leaders and institutions that now encompasses civil, cultural, educational, economic, and Constitutional dimensions. Americans are a practical people: they expect things and people to work, including their leadership.

Consider the non-stop headlines, some small, some large, all cumulatively indicia of a mechanic of dysfunction of large magnitude. It has financial implications.

Let’s start with the Fed, and we’ll quote our last posting which reflects our continuing view:

“We believe the Fed is in fact looking for an unwind strategy but can't find one.  A financial Burdian's Ass? Does any bale of hay contain an acceptable unwind? We've gotten a whiff of the revolt of the rational market investors squaring off on the 10 year rates at any sign of tapering which was not pretty.

Our take is that the Fed will do nothing intemperate, take an agonizingly slow incremental approach ... at least while all the knots hold. By this we mean near stasis. We suspect the probabilities are growing for a much longer & slower unwind than many contemplate. We are, however, unwilling to bet much of the ranch on it. The stasis scenario provides 'flexibility' for a strategy that is pinned to the hope of economic growth that may or may not materialize. One is tempted to suggest decades and for the intermediate period a near permanent increase in the money supply. Just a thought. Watch money velocity.” - THE FED, COLLATERAL AND REPO: MORE SYSTEMIC RISK?

The Fed, in pursuit of “transparency”, led the market to anticipate a “tapering” this week, or so some 67% of economists thought. After months of preparation & indications that “we will taper”, they did not. Hmmm.

“Federal Reserve officials created new uncertainty about how much farther they will push their easy-money policies—and new questions about how effective they are at communicating their thinking—with the decision to stand pat on the pace of their bond purchases for now.” Fed's Guidance Questioned As Market Misreads Signals

Paradoxically, the Fed is adding uncertainty as to the predictability of its short term actions but more certainty as to the ultimate outcome of its strategy. QE and the balance sheet of the Fed, which is now the largest undercapitalized hedge fund in the world, will have to be downsized, unwound at some point. The inflated asset prices it has created are not sustainable nor is the continual expansion of the money supply nor is the balance sheet of the Fed without market constraint. OK, but some problems arise. We don’t know the timing, magnitude, consistency, or forms of the ultimate unwind or market response. We do know that large complex things take time to process and adjust (or as the dinosaurs, die). We do not know the form of market response as it will be influenced by mode & timing of implementation.  Intuitively, we see two polar options: a potentially chaotic repricing of some magnitude or a gradual decline of our standard of living induced by inflation and/or lower productive economic output over time. Likely, it will be a more moderate combination of both. It is a huge Markov Chain. Look for rising risk premia.

One thing is certain: no jobs means no recovery, no growth. U6 is the green line. We basically have 15% of the country out of work. Equally disturbing is the youth unemployment: we are loosing a generation of workers which has huge long term cultural & economic implications. These wheels grind slowly but finely, and the fate of the black nuclear family comes to mind.  The Civilian Unemployment rate is simply misleading & does not count those who have left the labor pool over time for want of employment.

As to the inevitability of outcome consider this and ask if the trajectory is sustainable. Recall it omits unfunded liabilities:


Equities: But the juice works in the short term. Set aside for a moment that steady decline in real median family income and take a look at the ride in equities: Obama and Bernanke have delivered for the 1% like nobody's business.

US and non-US equities have put up great numbers. It seems extended low growth with expectations for the grind to continue in the US has been sufficient to buy Euroland and Asia some time to put their houses in semi-order. We remain skeptical of expectations for higher growth in the US. Evidently, so does Mr. Ben.


Large, mid and small caps all up: beta wins.  These are outsized gains clustered within a relatively small time frame. 

Growth or value pretty much didn't matter.


Fixed income: we know too well the implications for continued manipulation of zero to negative real interest rates. It is a coersed wealth transfer from savers & risk constrained investors to borrowers. You get no or negative real return on your fixed income investments, and the borrowers (including the US government) get the interest you do not. It’s pretty simple. In a macro perspective every fixed income investor (from Grandma to Bill Gross) become poorer. Real rates have increased substantially in proportional terms, and we suspect more to come... when is the question.

Meanwhile fixed income investors have learned a harsh lesson: maybe Grandma shouldn't hang out in long bonds. More learning to come?


We note again there are only three ways to get yield in fixed income: duration, credit risk, or liquidity risk. As the Fed starves the market of real interest rates, it drives investors out the risk curve along any of those parameters. So, if you buy the thesis that the current game is not sustainable, do you load up on duration, credit or liquidity risk when you know the markets are distorted by the Fed at the precise time when the Fed has demonstrated you cannot rely on its indications of policy? We think not, unless you have impeccable market timing which, by the way, neither you nor we have.

We maintain our bias to short duration investment grade product. A diversified portfolio with a duration of 2.7 pays a spread of .97% over the interpolated Treasury rate. Consider that the 3 year Treasury currently pays .87%.  The credit spread is more than the underlying Treasury, not a bad value.  We caution against chasing yield: it never ends well. You just can’t get 8% in a 2.75% market.  Remember that next time PT Barnum starts pitching you.

Our outlook: We anticipate low growth and increasing risk premia induced by the Fed, ill conceived regulations or geostrategic blundering. We look for sluggish employment and weak capital expenditures. Every dimension of fiscal, monetary, social, energy & tax policy is directionally wrong from an economic perspective. Paralysis may be the best hope as a least-worst outcome. We anticipate Ms. Yellen will be the nominee to head up the Fed and do not anticipate that she will raise rates in face of a congressional election year and certainly not in a presidential cycle, but as they say, the opera isn't over until the fat lady sings.

Stocks and bonds will respond favorably as will all risk assets. Everyone may well join the drunken pig pile, and all the animals of the forest will be happy, at least for a while. Systemic risk & moral hazard will grow and long tailed risk will increase. We see near term risk of inflation as offset to some extent by slack capacity in the economy. 

For equities the good news is that globally corporate balance sheets continue to be in great shape (excluding financials) and well positioned for marginally decent earnings in a slow growth environment. There is much less opportunity for cost cutting & greater efficiency. Earnings growth will start to converge with nominal GDP growth.

It is no trivial matter for the asset class as a whole that corporate compensation models are much better aligned toward wealth creation. There is no such scheme with fixed income assets, save the anti-model of governments that are driven by grafted re-distributionism, so to speak, and incentives to inflate. Equities historically have been a source of high sustainable real returns, and we don't anticipate that will change. We do anticipate greater uncertainty which may manifest itself in greater volatility from here to there and stretch the time frames required for those expected returns to eventuate as business models adjust.

We'll close with two last comments. We see two major risks to long term investors. One takes the form of undisciplined investment programs that devolve to decisions driven by emotion which in turn subverts the asset allocation and risk management. The fog of uncertainty holds implications, again, for the importance of asset allocation and diversification. The other risk is inflation. If you think you can go to cash and sit this out, consider the picture below (reproduced from  PRE Q3: IT'S NOT AN EMPTY CHAIR, IT'S AN EMPTY WALLET).  Here's a hint: if the graph starts to get darker blue, you've probably lost 70% of your real value.



The Fed, collateral and repo: more systemic risk?

Updated on Saturday, July 20, 2013 at 05:13PM by Registered Commenterhb

Updated on Monday, July 22, 2013 at 09:44PM by Registered Commenterhb

Updated on Monday, July 22, 2013 at 10:11PM by Registered Commenterhb

We’ve had the FT article of April 23, 2013, The Misuse of Collateral Can Help Create Systemic Risk by Satyajit Das, on our desk for several months. It is highlighted and underlined, and we borrow from it liberally here (in fair use we trust). His article was prescient.

The thesis is simple enough: in the main collateral is now the basis of our primary financial institutions, most capital markets transactions, and source of liquidity, which is to say, our entire financial system. One might infer that collateral is what you use when you have no capital. He highlights, excerpted below, some consequences, intended or not, of the increasing dependency on collateral. Translation: “you can run, but you can’t hide.”

First, it shifts the emphasis from the borrower or counterparty’s creditworthiness to the collateral. Parties normally ineligible to borrow or transact in the first place are able to enter into transactions. Rapid growth in debt levels, derivative contract volumes and the shadow banking system (hedge funds or structured investment vehicles) are dependent on the use and availability of collateral.

Click to read more ...


A little more perspective

Updated on Tuesday, July 2, 2013 at 11:11AM by Registered Commenterhb

Updated on Tuesday, July 2, 2013 at 11:25AM by Registered Commenterhb

Updated on Tuesday, July 2, 2013 at 03:39PM by Registered Commenterhb

Our last posting, A Bit of Perspective regrettably promised further thoughts on recent market events, so here we go. First time readers may want to take a quick look at the graph in the original posting. It is our starting point.

We are not unduly troubled by the recent volatility in the market. You have to place it in a longer term context of a huge bull run in equities & the perils of the Fed artificially fixing prices for a long time and then changing its mind. So, we wash out some levered players, and some folks start to get a clue as to the perils of duration. We don’t mean to be dismissive because we do watch this closely, but it’s not the short term noise that gets our attention, it’s the underlying tectonics.

The key issues are quite large, and no one in government is asking, or we might hypothesize has the capacity or inclination to understand, let alone fix.

We start a simple question, “What caused the damage to the fundamental fabric of the real economy?”

Click to read more ...


The failure of governance and the uncertainty curve

Updated on Thursday, February 7, 2013 at 06:56AM by Registered Commenterhb

Updated on Friday, February 8, 2013 at 05:09PM by Registered Commenterhb

Updated on Monday, February 11, 2013 at 08:42AM by Registered Commenterhb

Updated on Friday, March 15, 2013 at 10:02AM by Registered Commenterhb

Phineas Taylor Barnum constructed and marketed his fraudulent Figii Mermaid to the crowds, and his spirit lives on.  

"I am a showman by profession...and all the gilding shall make nothing else of me,"[1] .  

At least Barnum, setting aside for a minute the notion of authoring two autobiographies, remained sober in his perception of reality.

For stark contrast we would highlight for the attention of our national policy makers that certain corporate issuers of investment grade debt have periodically traded at negative spreads to their US Treasury benchmark, that is at lower rates than the comparable Treasury note.  A capital markets redux of The Emperor's New Clothes

Click to read more ...


pre q3: it's not an empty chair, it's an empty wallet

We’ve run silent for a while with good cause. Those with whom we speak know our distraction with and consternation about some corporate governance issues well away from WWB.  Our homily for last two quarters is, like QE3, ubiquitous: know before you go. More on that later.

The core issue for our silence has been that we've had nothing to say, at least nothing that made any particular sense. We were mesmerized by the magnitude of the geopolitical & macroeconomic frogs in global blenders and by the scale of cynicism marking the political hegemony.  What is it, "if you can't say anything nice, don't say anything"... well, our readers know we missed that bus a long time ago.
We have accelerated the quarterly review process for our clients because we wanted to be tucked in before the end of this quarter in light of the election and the potentially massive recasting of portfolios driven by tax windows and political outcomes. 

Talk to your tax advisors now

We suggest all check with their tax advisors to get a grip on their expected marginal tax rates next year; review any embedded long term capital gains and implications of future rates; and make sure you have adequate liquidity to tide over any potential geopolitical stress or untoward political outcomes domestically. 

QE3: Who made the Fed the 4th branch of government? 

The Fed has manipulated the rates for some time and now with the advent of QE3 the price of money will be determined by fiat of the Fed, whether driven by putatively leading economic thought, whimsy, or political objectives... exactly the same way FDR did in 1933. Amity Shlaes wrote a fascinating article in the WSJ on FDR and the notion of confidence, part of which is excerpted below:

Over the summer of 1933 ... Roosevelt launched a novel gold purchase program. The plan was to drive up the general price level by buying gold. Each morning, FDR set the gold price target, personally ... theoretically, Roosevelt's idea of reflating can be defended... but the exposure to investors that Morgenthau was getting through the gold purchase project of 1933 was already teaching him something. Investors didn't like the arbitrariness. It took away their confidence. One day Morgenthau asked FDR why the president had chosen to drive up the price of gold by 21 cents. The president cavalierly said he'd done that because 21 was seven times three, and three was a lucky number.

FDR, Obama and Confidence

That’s Bernanke today, and as we’ve said before “One might then reasonably inquire as to how and on what rational basis ... other than that to be found in a room, dimly lit by burning candles, with chalk pentangles and splatters of chicken blood on the floor ... how do they evaluate risk of this market which funds, essentially, the entire financial system of the known world.” 

The consequence of artificially low rates is a wealth transfer from the investor (you) to borrowers. Crudely put, you get low to no interest income while borrowers get low to no interest expense. Good for borrowers, bad for investors including retirees, your mom & dad, pensions, or anyone who wants to start saving…like young people with or without families. These are big, large scale numbers with generational implications for capital formation. The low yields are only one small part of the silent transfer of wealth & risk that is ongoing. 

Let’s talk about risk, shall we? 

In fixed income risk comes in two forms, duration & credit. Fed policy is attempting to force investors to load up on both. We all know what credit risk is: the weasel is shaky or doesn’t pay you back (Greece or General Motors come to mind, yes? Junk bonds? Your esteemed Uncle?). Duration is a measure of interest rate risk. So, for simple example, if you have duration of 14 as many long term Treasury funds do, and 14 year rates go up 1%, you just lost 14% of the value of your bonds. If the rates go up by 2%, then you lose 28% of your value (kind of a big numbers for purportedly low risk investments, don’t you think?). This is a big deal.

In fixed income there are only two sources of yield: duration or credit risk (let's ignore liquidity premia for the moment). Oh, by the way, these price changes and risk parameters move instantaneously with expectations, so the bond manager (or you the investor) needs to ask if he feels lucky today? Will the center hold? Long enough for me to pick up another coupon payment before expectations collapse? Well … do you?  Or maybe your grandmother shouldn’t own all those long term bond funds?  The Fed is force feeding markets. The investor who stays short forgoes yield, and retail investor who goes long does so by incurring duration risk. It will not end well. 

Inflation risk

Ah, the printing press. Another component of QE3 is the hidden cost of inflation, that part of price changes induced by excess money supply. When you look at the chart below, recall that Jimmy Carter took the title, as it were, with 14.8% inflation in March of 1980. It can & did happen. When you have monetary & fiscal policy created by the belief that $1.00 of government spending creates $1.50 of GDP and that belief continues to drive policy absent supportive data or in fact even in face of contra-indication… you may have a problem, particularly when you’re borrowing $.40 of each $1.00 you spend.

As you look at the graph below imagine it to be 3 sides of cardboard box with two walls and the top cut away. We drape a light blue cloth (a “surface” in math speak) along the upper left hand wall. Go the far upper corner where we start at $100 at time 0 with 0% inflation. You can see the real value stays at $100 where ever you are on the time line at 0% inflation. The front left axis of the floor of the box is the level of inflation running from 0 to 20%, and front right axis is time in years. Go to the rear wall, pick a line on the cloth (the first one is 1% inflation), and slide down the time line across the drape to the front.  Presto! You get something less than $80 in real value at 1% inflation over 25 years. 



Just so you know, the low points (closest to you, lower center, darker blue shade are the longest timeframes & higher inflation rates) represent about $1 of real value. You get the picture of a pretty severe loss of value over time even with fairly modest inflation: 3% inflation over 25 years kills half your purchasing power. That’s a big deal for individuals planning their retirement or for anyone including insurance companies or banks or corporations trying to fund assets or liabilities in the future. It’s a very difficult box to get out of.

the men would get paid in the morning. they would take pillow cases, put the cash in the pillow cases, walk over to the wall, and throw the bags of money over the wall to the women who would go out shopping, to spend the money before the merchants raised the prices in the afternoon...

source: as told to my friend LG by his grandfather on life in the Weimar Republic


Just witness the 25 basis point surge in break evens in the hours following the Fed’s QE3 announcement on Thursday last week, representing a “5-sigma event” for this market-measure of inflationary expectations.

source: Mohamed El Erian in Introducing the “reverse Volcker moment” Sept. 20, 2012

As you look at the graph ask yourself how do I price assets of any kind when I’m looking at a surface of real value that declines like a large water slide at an amusement park? This is how government lowers our standard of living. It is how government levies taxes without the consent or vote of the people. No elected official “votes” for “Quantitative Easing”. Who made these clowns the Fed an unelected 4th branch of government?  … but we digress into outright political control of the broad market economy.

There are very few places to hide, and those are imperfect places. This is not a pleasant time to be either an investor or in the investment management business. The general form of problem is that the Fed has manipulated the “risk free” rate to zero and announced it will print money without limit of time or amount. This causes two tectonic problems. It distorts asset price information and induces inflation risk. 



Real yields for US Treasuries with maturities less than 20 years are negative. This is the bond bubble. What value could there be in a 20 year bond with a real yield of 0%? We suspect very little positive value and potentially significant negative value. How shall we know? Ask Ben.

The problem of the “bond bubble” does not stop with bonds. The US$ is the global reserve currency, and the US Treasury market sets the benchmark for global asset pricing. As the Fed pushes investors out the “risk curve” the distortion of the Treasury market ripples across the globe and across prices of all asset classes. 

Recall that in response to instability of Euroland we saw investor flight out of the Euro and into the US$ and Treasuries which became too expensive, no yield, then catching its breath, the herd swarms into emerging markets debt & high yield debt which became too expensive, then into US equities generally, and particularly dividend paying stocks, which perhaps have become too expensive, or onto real estate which was previously too expensive and the proximate cause of the initial collapse? Or commodities that reside in bins? Or gold which has no earnings, no P/E ratio? The uroboros eats its own tail.

Add to this the uncertainty of the entire tax code, regulatory framework, the outcome of the US election, clueless Europe, Islamic instability on fire globally, with what appears more & more each day as a failed state on our southern border, not to mention the one in Washington.

Investment strategy

Our view has been that inflation is the primary risk to investors and that view defines portfolio & risk strategy. Of course, the solution is sustainable high real returns but there just isn’t a perfect solution, and there are no risk free solutions. An optimal strategy likely takes a form of ‘least worst’. Our general preference in relative order would include equities, real estate, commodities, short Treasury bills, inflation indexed bonds, and short duration spread product, all defined within prudent diversification and risk parameters.
Asset allocation

We do not anticipate significant changes in terms of existing broad asset allocations for most clients. That work has already been done & is embedded in the existing portfolios. We will be inclined to increase our exposures to real assets beyond the positions embedded in existing index product by adding slices of gold or silver, the size of which will vary by client risk tolerance.
On a good day the asset allocation decision already incorporates one’s ability to tolerate risk. We see nothing on a macro basis that would induce us to start adjusting those dials significantly for our clients. Risk tolerance will be the driver.
Fixed income

As a general comment we’ve had a legacy core bias to short duration investment grade credit augmented by moderate positions of inflation indexed product, emerging markets debt, and domestic high yield. We’re still inclined to avoid duration and favor short Treasury Bills, inflation indexed bonds, short investment grade spread product. We’re not buyers of high yield or emerging markets debt at these levels.  We’re content to hold for now.
We’re scared to death of municipal credits but suspect there may be value in certain long duration AAA/Aaa floating rate municipals. Ah, wouldn’t we all like to float or drift as the case may be?
Solutions to the inflation challenge can be problematic in that many investors simply lack the scale to tolerate the risks associated with the most robust effective classes or lack access to solutions which reside in the capital markets (e.g. interest rate swaps). What can we say, scale counts: “It’s good to be the king.”
Why not increase equity exposures?  

By all means if you've got the risk budget and faith in Ben. It has been a significant 3 months for virtually anything: US equities, non-US equities, emerging markets, and gold.  QE3 in connection with a slow grinding economy can do wonders. So do steroids, but there are bad side effects. 


While we believe that equities represent the best shot at sustaining higher real returns over time, we also recall the notion of Mr. Bernanke forcing investors out the risk curve. He has made some very large scale bets on a questionable basis. If it ends badly, the equity markets globally may be damaged or radically repriced along with all the guinea pigs herded out the risk curve.

We suspect the Treasury “bubble” has become ubiquitous, spreading to virtually all asset classes globally including equities. Historically, the US equity markets have been characterized by the stability created by a permanent equity market & investor class. Neither Asia, Europe, nor the emerging markets can make that claim credibly. In a heart beat…poof… they can go. Such things happen in panics.  US equities traditionally have stayed, we were open for business after 9-11. 

But things change. We started by saying that we view inflation as the primary risk. But are we not in a growth constrained and credit stressed environment too? The tertiary risk is an untimely, chaotic repricing of the distortions induced into the markets by imprudent fiscal policies & coercive & synchronized monetary policies globally. The risk is that Bernanke, the US Treasury, Congress, and the President, perhaps in conjunction with exogenous forces, unwittingly damage the fabric of the US capital markets and the investor class. We no longer assign a de minimis risk to that outcome. It's already started.

Look at what they did to our bond ratings. 



What's wrong with the Fed

John Cochrane of University of Chicago provides the best explanation of why & how the Fed is off track in his recent article The Federal Reserve: From Central Bank to Central Planner



Jim Rickards on the latest Federal Reserve Rate Decision and Operation Twist 2.0

For a lucid view of the recent Fed action in global context watch this:

Jim Rickards on the latest Federal Reserve Rate Decision and Operation Twist 2.0

It's a bit long, but worthwhile. Of particular interest at the back end are his comments on structural rent seeking and the costs it creates for our economy. Rent seeking translates into the political form of your risk, my return.   Moral hazard, the kudzu of our current regulatory framework, is the fountain of rent seeking, and it's everywhere ... 

  • Too Big To Fail whereby the entire loan & swap books of the TBTF institutions are underwritten by the US taxpayer
  • the failure to reform money market funds and the repo market and  the consequent expectation of federal support for funds which have no independent capital or collateral to support trillions of dollars of credit,  counter party & clearing risks
  • Fannie & Freddie which were essentially untouched by Dodd Frank and comprise about 95% of the entire US mortgage market and
  • pick a sector: health carer, automotive, education, pensions, energy etc.

We missed a lot, but you get the picture. We continue to manufacture boatloads of systemic risk by moral hazard. It is not a cost or risk free proposition.  And our politicians monetize for their own benefit their ability to allocate the privilege. No one seems to address the loss of freedom which accompanies the growth of moral hazard, but it is very real.

Lastly, an excerpt from an article on the SEC & money markets in today's WSJ:

Money market mutual funds have been rescued from financial trouble by their parent companies more than 300 times since the 1970s, about 100 more than previously reported, according to a new Securities and Exchange Commission study.

The study, which isn't being released to the public, appears to bolster SEC Chairman Mary Schapiro's contention that the $2.6 trillion industry needs stronger regulation

Wait a minute: "The study... isn't being released to the public"? One might reasonably ask, why not?  How are citizens to make informed decisions about what might be one of the most important regulatory & structural issues of the decade when key information is withheld? 

And if you're considering your freedom you might want to ponder the answer implicitly proffered: you don't need to know... if we wanted your opinion, we would ask.




Choosing the Road to Prosperity: Why We Must End Too Big to Fail –Now

If you haven't seen this you should: Choosing the Road to Prosperity: Why We Must End Too Big to Fail –Now . We commend the Dallas Fed for putting it together.

If we don't fix the issue of moral hazard (Too Big To Fail) we can't have a market oriented economy. It's that simple. Read this in connection with our very own Reforming Money Market Funds: A Response to the Squam Lake Group.

It must change.


FHFA-OIG’s Current Assessment of FHFA’s Conservatorships of Fannie Mae and Freddie Mac

We present a link to and an excerpt from a report by the Federal Housing Finance Agency, Office of the Inspector General. We believe it is important and suspect it will receive limited coverage because it is counter to the currently fashionable narratives. The short story is one we already knew: Fannie & Freddie are big time bust. And don't you know Dodd-Frank is silent on the topic. Well, why not? Both those Senators were essentially parties at interest in Fannie & Freddie.

As to the matter of large scale capital flows & macroeconomic outcomes, our country is slowly awakening to the quaint, old fashioned notion that results & outcomes matter.  They matter very much. 

White Paper: FHA-OIG's Current Assessment of FHFA's Conservatorships of Fannie Mae and Freddie Mac

"As a practical matter, however, the Enterprises’ future solvency – and, thus, emergence from the conservatorships – is unlikely without legislative action. FHFA officials have stated that the PSPAs have made it virtually impossible for the Enterprises to emerge from the conservatorships. For example, the Enterprises currently owe Treasury $183 billion, and are required to pay 10% dividends on Treasury’s outstanding investment. Merely paying the 10% annual dividend (i.e., $18.3 billion, presently) would not reduce Treasury’s outstanding investment. Moreover, the Enterprises have had to borrow from Treasury at least part of their dividend payments to Treasury, thus increasing the value of their outstanding debt. As a result, it would appear highly unlikely – if not mathematically impossible – for the Enterprises to buy themselves out of the conservatorships. FHFA’s Acting Director has stated that:

[T]he Enterprises will not be able to earn their way back to a condition that allows them to emerge from conservatorship. In any event, the model on which they were built is broken beyond repair... "

The magnitude of these losses are huge, the loss of national wealth permanant, and the burden on the US economy and younger generations of American huge... all driven by defective policy and corruption. For insight into the nature of corrupted governance & markets we recommend Reckless Endangerment by Gretchen Morgenson.

Private markets provide mechanics for change of governance in face of failure. That mechanic seems to be lacking in the political arena. The same political class continues to regulate increasing sectors of our economy by the same defective methods. The agency costs of failed political goverance are too high to sustain. Remember the wisdom that brought us here: we see it repeatedly in the regulation of financial markets, health care, and Fed policy.

 "on the basis of historical experience, the risk to the government from a potential default on GSE debt is effectively zero" Implications of the new Fannie Mae and Freddie Mac Risk-Based Capital Standard by Robert & Peter Orszag and Joseph Stiglitz, 2002




Reforming Money Market Funds: A Response to the Squam Lake Group

Updated on Tuesday, March 20, 2012 at 10:00AM by Registered Commenterhb

Updated on Monday, April 16, 2012 at 09:29AM by Registered Commenterhb

Updated on Friday, April 27, 2012 at 10:38AM by Registered Commenterhb

Updated on Friday, June 8, 2012 at 10:44AM by Registered Commenterhb

Updated on Thursday, June 14, 2012 at 01:36PM by Registered Commenterhb

Updated on Friday, June 22, 2012 at 10:06AM by Registered Commenterhb

Updated on Monday, June 25, 2012 at 11:40AM by Registered Commenterhb

Updated on Tuesday, November 27, 2012 at 09:28AM by Registered Commenterhb

The money markets are central to critical issues such as credit creation, systemic risk, and investor confidence. They function on a macro level to allocate globally short term credit, unsecured in the case of commercial paper, and secured in the case of repo.

Money market funds are defined in the Investment Company Act of 1940 Act and influenced by investor preferences as expressed within that regulatory framework. Historically and as a practical, functional necessity the money markets have been geared to the very lowest levels of perceived risk, which is to say very short term exposures (average maturities of 30- 45 days) to the very highest quality credits. Historically, one whiff of trouble … reputational, credit degradation, informational risk or whatever is not clear and simple… and you have investor flight, which is what happened to the TBTF’s (Too Big To Fail) in the Great Unpleasantness.

Today those same problems remain.  Money funds today operate with no capital whatsoever. They are cash repositories and warehouse massive systemic risk: broadly put, short term, rolling AA- credit & liquidity risks ... sovereign, corporate & financial.  And the nature of that risk has qualitatively changed for the worse over the last decade.

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That which is seen and that which is unseen by the Fed

Updated on Monday, February 6, 2012 at 09:01AM by Registered Commenterhb

Updated on Tuesday, February 7, 2012 at 08:22AM by Registered Commenterhb

Updated on Monday, February 13, 2012 at 08:05AM by Registered Commenterhb

The testimony of Ben Bernanke yesterday (2/2/2012) to the Committee on the Budget of the U.S. House of Representatives was marked by an assertion as to the health of the US capital markets, that in response to a question that cited an opinion piece in the WSJ by Kevin Warsh excerpted below:

 "Private investors are crowded out of the market when the Fed shows up as a large and powerful bidder. As a result, the administration and Congress make tax and spending decisions—with huge implications for our standard of living—with heightened risks around future funding costs."

The transcript of the testimony has not yet been published as of this writing, so we quote, sort of, Bernanke's response:

 “The capital markets are all okey dokey. Never better. Next question.”  

We return to that issue because we disagree. We think the narrow context of his response is facially misleading. First, we stipulate

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Legal & settlement considerations in various Euroland scenarios

Pillsbury Winthrop Shaw Pittman, LLP, has published an important advisory bulletin Cracks in the Eurozone.

It provides a helpful primer to understand the magnitude and uncertainty of the large scale contractual processes at work in Euroland.

More later.


Caedite eos! Novit enim Dominus qui sunt eius

Updated on Wednesday, January 4, 2012 at 09:48AM by Registered Commenterhb

Updated on Thursday, January 5, 2012 at 08:20AM by Registered Commenterhb

Updated on Friday, May 4, 2012 at 08:55AM by Registered Commenterhb

We probably should talk about investments, although what I want to do is rant about our domestic policies which are destroying so much of our economy, so much of our national value. We'll get to both, and pictures are a good place to start.

This year's markets were uninspiring at best, frightening at worst. US equites struggled to hold near even while foreign markets, both developed and emerging, suffered. As always we select broad indices for illustrative purposes and note these are graphs of prices, not total returns.

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Kurtosis and systemic risk: policy makers need to get a clue

When we see phenomena we think we intuitively understand, and it's important, we try to kick the tires a bit. Intuition is good, confirmation by fact is better. Here we take the S&P 500 for a broad proxy of the US equity market and further take VFINX, Vanguard's 500 Index Fund, as our guinea pig. We downloaded 10 years of daily data and found some of the pictures of interest, some entertaining, one vitally important. Here we go:

Here is the time series of daily price data from Jan. 3 to Sept 27, 2011 downloaded from Vanguard. You know its ugly, but take a look anyway.

Here is the same data sorted by % size of daily gain or loss. Less ugly, but only due to style of presentation. If we hadn't put the drop down line in, it might have passed for semi normal. But it seems a little longer on the left side, yes? Of the 185 data points, 100 are negative.

Same data displayed differently, or as a matter of conceptual art perhaps a "splatter chart" of someone's viceral reaction hitting the floor.


So how does this volatility stack up to a decade of price behavior?  Below we chart the minimum and maximum one day % changes of the past decade (specifically from 9/21/2001 to 9/27/2011). Well, so far it seems there are only three worse years:


Interestingly, so far this year's standard deviation in and of itself is about average, but the dispersion seems to be increasing.


We took at look at the kurtosis over the last decade. You can see the definition in the picture (bolding courtesy of editor). The trend since mid to late 2007 is not encouraging. Others have found similar results, that is increasing excess kurtosis, in the yields of 90 day T-bills. This is systemic risk.


This bears particular import for the operation of global capital markets, and in particular for alternative assets as a class. Most of the literature we've seen indicates that adding alternative assets to portfolios of traditional asset classes can increase kurtosis of the overall portfolio (think pensions & endowments) if unartfully done. We also suspect that the notion of kurtosis induced by alternative assets isn't even examined in by most small institutional & retail investors. And certainly most alternative assets are soldpresented on the basis of mean variance risk/return space which is the quintessential apples to oranges.

Policy implications

At some point the Fed, regulators, and policy makers have to get a clue. They are manufacturing systemic risk and mere repackaging doesn't help. Granted some of this is spillover form Europe, but at the end of the day in the financial sector we still have large scale asymmetry in the treatment of the too big to fail financial sector, that in the form of socialized risk and privatized return. We are still left with increasing aggregates of black box counter-party risk. 

We have utter chaos in the regulation of the non-financial sector, and we have a chaotic tax code that incents the mis-allocation of productive capital. And they continue taking economic water out of one side of the bucket to put in the other side without regard to leakage or fundamental damage to the bucket....We note that free trade bills have languished without action for the last 3 1/2 years; the Senate undertakes consideration of Currency Exchange Rate Oversight Reform Act, our very own modern version of Smoot Hawley; an energy policy designed to throttle exploration & production; and a Rube Goldberg tax code.

But the good news is that the market and the United States has the ability to suffer through the current toxcity of policy and leadership.  No doubt the outcome of the election will impact valuations. Intrade now prices the probability of BHO's re-election at 47%.  Even with a sensible regime change, we're in for a long slog, but we're is not ready to piss on the fire and call in the dogs1

In the context of a seven to ten year time frame equities are not unattractive at these levels, but the meaning of the kurtosis graph is that you better buckle up. The investment premise is simple: you'd better not be investing for near term value. Getting from here to there will be the trick, and adaquate liquidity will be important.  If we get some sensible policies in place and some new leadership, then the values offered today may very well look compelling 7-10 years forward. But as our President is known to say, "let me be very clear": it's going to be a bumpy ride from now to then.


1  Colliquial expression of cultures in the Appalachian & southwestern regions of the United States.


Observations on foreign bank liquidity

Today's WJS  advises that

For the past three months, European banks have been largely unable to sell debt at affordable prices to investors, who are wary of the banks' vulnerability to risky euro-zone government bonds and other loans.

At $34 billion, the amount of senior unsecured debt issued by the Continent's financial institutions this quarter is on track to be the smallest of any quarter in more than a decade, according to data provider Dealogic. - Europe's Banks Face New Funding Squeeze

Let's see ... from more than $250 billion in QI and QII in 2009 to $34 billion.

We looked at the short end of the curve and see that the foreign financials have racked up a 28% decline in outstandings since the peak in June (see the big red arrow below).

Bloomberg reports

The eight biggest U.S. money-market funds reduced their investments in French banks by 46 percent to $42 billion in the past 12 months, data compiled by Bloomberg and published Sept. 9 in the Bloomberg Risk newsletter shows.

This is particularly precarious for banks, given that liquidity pressures over year end can be stressful even in good years. Saavy liquidity managers are starting now to fund through year end, but there is, evidently, a substantially declining bid for even the shortest of foreign financial paper in our domestic markets.

Where does it go? The Euro commercial paper market is simply too small and, oops, low-to-no bid there anyway.

Below we present outstandings of various segments of the US commercial paper market:

This is the US$ funding crisis everyone's been anticipating. Last we heard France was trading around 1.96% for 5 year credit default swaps, and Italy about 5.03%, so its not clear that sovereign support for the banks will bring much to the party. The Germans need to play.

If there is some good news it is to be found in the blue & green: there is a growing supply and demand for non financial domestic commercial paper. It's good to see some credit creation, however modest and the financial outstandings seem, well, sideways is good enough.