The dramatic pull back by buyers of credit has dominated m* mindshare for well over a week now. So far, the magnitude of spread widening, the breadth of credit markets effected, the spillover into equity markets and hard assets driven at the margin by speculative players (think gold and uranium) and the rally of traditional safety trades - US treasuries and the Yen, feel like a pretty run of the mill normalization with respect to the size and duration of the credit inflation that has been in place since 2002.
The global economy is still running hot, with central banks around the world in tightening mode. Corporate earnings are coming off peaks but are still healthy. Corporate balance sheets are supposedly in good shape. Hungry trillion dollar pools of liquidity at sovereign wealth funds are waiting in the wings. It is plausible that this bout of indigestion on the part of the credit consuming investor will soon pass, with some capital exchanged for yet another lesson in the tradeoff between risk and reward, and calls for more stringent rating agency definitions.
Then again, the underlying tone of the US economy is weakening, not strengthening. Soon enough, export driven economies should start to see weakness in exports, and m* will find out exactly how much "decoupling" really has been achieved. One suspects, not enough. At the same time, central banks globally are reluctant to ease financial conditions with the current global inflationary pressures. It is also unclear how the US central bank would incorporate a continuing slide in the dollar into the picture.
Meanwhile, we are getting a real-time lesson in how the post-bank credit system manages a credit contraction. In the credit system of yore, risk was concentrated at banks, who specialized in evaluating loan(default) risk and warehoused portfolios of loans, earning a spread on their funding and borrowing rates, less losses for bad debts. The world has moved on.
Banks today are middle-men, preferring to provide advice and intermediation services between borrowers and lenders for a fee, rather than provide term capital. Certainly banks provide tremendous amounts of what you might call liquidity capital in the short term, for transactions and trading. But in the traditional sense of the word, they lend only reluctantly, as the recent pile-up of LBO commitments on bank balance sheets demonstrates. When your loan only brushes cheeks with the bank's balance sheet on it's way to a nice fee generating CLO structure with willing buyers, banks will fall over themselves to "lend." Without that CLO buyer, however, today's deal flow can exhaust already highly levered bank balance sheets very quickly.
Much has been made of the ability of derivatives and structured credit products in particular to repackage and transfer risk, in effect democratizing access and dispersing it to greater numbers of willing holders. This would seem on balance a good thing. The risk of default is spread across a wider range of investors, each safer for holding just a sliver of each individual loan.
However, a dispersed market for default risk introduces another more volatile problem in the way of market risk. In this marketplace with everyone long credit, the spillover from even relatively isolated credit events, much less a wholesale re-evaluation of the price of risk, can effect a wide cross section of participants. Avoiding (possibly temporary) losses then compels participants to seek more liquidity simultaneously leading to dramatic prices fluctuations such as we have seen over the last several days. The ability of participants, especially levered ones, to withstand even temporary markdowns becomes a primary concern for everyone. Because everyone is everyone else's counterparty, the dispersal of risk makes the system more vulnerable, not less, to seizures and crises caused by credit events, or fear of credit events.
The Fed of course as the "lender of last resort" has great power to re-liquify the system by cutting over night borrowing rates for member banks. By lowering bank funding costs for short term liquidity capital, the Fed provides headroom for banks to ease their credit terms to levered buyers, ie: prime brokerage financing for hedge funds, making it less necessary to raise capital by selling positions. The LTCM crisis was an early test of this mechanism.
Another feature of this new financial system is an increase in the supply of credit. With the new financial technology, banks are able to radically increase the number of times they recycle their capital, (their inventory turns in effect), multiplying the amount of credit in the system. The extent of that credit at this point in time is staggering and unprecedented. According to a tabulation done by the FT, the pipeline for announced deals is half a trillion dollars, equivalent to roughly the market capitalizations of Citigroup, Bank of America, and JPMorganChase combined, (or one year of operations in Iraq - but that's another story). And the vast majority of that financing is going to fund corporate acquisitions, not capital investment.
Surprisingly, central banks have failed completely to address this usurpation of their power to control the credit in the system, choosing to focus instead on the more mundane and technical issues of money supply. Meanwhile over-abundant credit has driven speculative bubbles in technology spending, residential real estate, consumer spending, and now corporate buyouts. Some might attribute tactical policy errors for one or two of these, but the nearly uninterrupted fall in long term interest rates and credit spreads and the concurrent rise in asset prices over this period ought to have raised questions. m* is still looking for that discussion.
Where do we stand now? Is this the beginning of the long unwind? It is hard to conceive how the system proceeds any differently from here. The bank sector is still of primary importance in processing these risk transfers. In the short term, until there is some visibility on how much unsold deal debt ends up on bank balance sheets, and what markdowns it takes to move it, the financial sector will remain under pressure. In the longer term, corporate fundamentals matter. If international development continues to support corporate fundamentals, buyers will return, capital will be freed up, and the credit cycle can continue a while longer as part of the globalization trade. This will have been a "contained" financial hiccup.
The bearish view depends on a number of perceived linkages about which m* is less sure, though no less concerned with. In this view, the US housing recession leads to a consumer recession which leads to a China recession which leads to a corporate recession which leads to falling financial assets. In this scenario, Fed rate cuts have limited ability to stimulate the consumer or corporates and the dollar falls to new lows, and long term rates rise with reduced inflows overseas capital and the return of long term risk premiums. It is an easy jump from here to there for the economic moralists, and they may be right, in the end. As m* enjoys the blues hour www.wbgo.org, he is just hoping it does not rain all weekend.
Friday, July 27, 2007
Thursday, July 19, 2007
Undercurrents
m* has been digesting the torrent of "progress reports" and related commentary, all released over the last day or two. The trends in place before this week are still in place. China is expanding at an astounding and accelerating rate. As measured inflation is at the higher end of our official comfort zones with housing pressing down and global growth pressing up. Forecasts for US growth are coming in a touch with consumer spending starting to soften. But the Fed remains on hold, mindful of the connection between food inflation and un-anchored expectations, while also keeping an eye on stress in the financial sector, etc, etc... Meanwhile oil continues to climb and the dollar continues to melt. This is not new.
However those buyers of bonds back to 5% are to m*'s way of thinking playing a game whose rules may have changed since the last financial crisis. Granted, is there anyone who has not been conditioned since this liquidity party started two decades ago to believe it is the central banks' responsibility to answer any and every crisis that threatens the steady march of credit expansion with a flood of cheap money to allow the party to continue? Probably not. We know the no consequences Greenspan put has replaced decades of dour punchbowl management.
But central banks now face a tougher set of conditions than they have in the past. The global economy is synchronized like never before and running full tilt. Inflation, not just the dollar weakening kind or the asset price kind, but real inflation, is starting to crop up in all sorts of places and is as globally linked as the supply chains that feed our people and our economies. For example food prices were reported as rising at 4.5% or higher in the US, China, and Israel this week. Central banks around the world are in tightening mode as inflation targets are being exceeded and expectations risk becoming un-anchored. The benign inflation environment that has existed for two decades and allowed central bankers considerable latitude to lower rates rapidly in response to fluctuations in the supply of credit no longer exists.
Central bankers today face a decision that was par for the course for bankers of old - whether to choose the primary goal of price stability or the secondary goal of full employment? In previous eras, central bankers felt obligated to occasionally put the brakes on, to allow unemployment to rise, even to cause it to rise by raising rates. However that has become much harder to do these days. With the shift from bank lending to capital markets finance, the opacity of credit creation through derivatives, and dare I say it, an intolerance for hardship of any kind among voters. These days the levers at the Fed's disposal need to move much farther to have an impact while the will to move them may be less than ever before.
The Greenspan era Fed, with it's belief in a new and "permanently" higher rate of productivity afforded by the internet (!) and an intense fear of a Japan style deflation (remember "helicopter Ben" and those used car prices?) believed to the horror of monetarists and economic moralists everywhere that it had the power to choose full employment without affecting price stability. However, like the trade deficit, entitlement healthcare spending, tax breaks for the rich, profligate oil usage, and ill-conceived and incompetently run wars in foreign lands, that is check written that must eventually be paid (in devalued currency naturally). The dismissal as a society of difficult trade-offs and hard choices is a symptom of these times.
What about the unprecedented amount of leverage in the system? Does that not mean the banks can talk about vigilance all they want but will still be forced to rescue asset markets and leveraged financial intermediaries should a crunch occur? Perhaps. At the margin, what matters is employment - the Fed's second policy goal. Changes in asset prices by themselves do not factor into the Fed's employment calculus. Wealth effects - the health of the "animal spirits" that incite both spending and entrepreneurial risk taking are probably real, as we've learned in the last housing boom. However, unless collateral can not get a loan, the current Fed leadership, steeped in scholarship on the Great Depression and the breakdown of credit intermediation as it is, may not be as sensitive to dampened spirits as the previous leadership seemingly was. Conceivably, there could be severe distress in financial markets, and even a pensions crisis, without a major policy change from the Fed. Only if unemployment threatened to pick up substantially would the Fed be obligated to shift policy.
Is the Bernanke Fed up to the challenge? It is an interesting situation to say the least.
However those buyers of bonds back to 5% are to m*'s way of thinking playing a game whose rules may have changed since the last financial crisis. Granted, is there anyone who has not been conditioned since this liquidity party started two decades ago to believe it is the central banks' responsibility to answer any and every crisis that threatens the steady march of credit expansion with a flood of cheap money to allow the party to continue? Probably not. We know the no consequences Greenspan put has replaced decades of dour punchbowl management.
But central banks now face a tougher set of conditions than they have in the past. The global economy is synchronized like never before and running full tilt. Inflation, not just the dollar weakening kind or the asset price kind, but real inflation, is starting to crop up in all sorts of places and is as globally linked as the supply chains that feed our people and our economies. For example food prices were reported as rising at 4.5% or higher in the US, China, and Israel this week. Central banks around the world are in tightening mode as inflation targets are being exceeded and expectations risk becoming un-anchored. The benign inflation environment that has existed for two decades and allowed central bankers considerable latitude to lower rates rapidly in response to fluctuations in the supply of credit no longer exists.
Central bankers today face a decision that was par for the course for bankers of old - whether to choose the primary goal of price stability or the secondary goal of full employment? In previous eras, central bankers felt obligated to occasionally put the brakes on, to allow unemployment to rise, even to cause it to rise by raising rates. However that has become much harder to do these days. With the shift from bank lending to capital markets finance, the opacity of credit creation through derivatives, and dare I say it, an intolerance for hardship of any kind among voters. These days the levers at the Fed's disposal need to move much farther to have an impact while the will to move them may be less than ever before.
The Greenspan era Fed, with it's belief in a new and "permanently" higher rate of productivity afforded by the internet (!) and an intense fear of a Japan style deflation (remember "helicopter Ben" and those used car prices?) believed to the horror of monetarists and economic moralists everywhere that it had the power to choose full employment without affecting price stability. However, like the trade deficit, entitlement healthcare spending, tax breaks for the rich, profligate oil usage, and ill-conceived and incompetently run wars in foreign lands, that is check written that must eventually be paid (in devalued currency naturally). The dismissal as a society of difficult trade-offs and hard choices is a symptom of these times.
What about the unprecedented amount of leverage in the system? Does that not mean the banks can talk about vigilance all they want but will still be forced to rescue asset markets and leveraged financial intermediaries should a crunch occur? Perhaps. At the margin, what matters is employment - the Fed's second policy goal. Changes in asset prices by themselves do not factor into the Fed's employment calculus. Wealth effects - the health of the "animal spirits" that incite both spending and entrepreneurial risk taking are probably real, as we've learned in the last housing boom. However, unless collateral can not get a loan, the current Fed leadership, steeped in scholarship on the Great Depression and the breakdown of credit intermediation as it is, may not be as sensitive to dampened spirits as the previous leadership seemingly was. Conceivably, there could be severe distress in financial markets, and even a pensions crisis, without a major policy change from the Fed. Only if unemployment threatened to pick up substantially would the Fed be obligated to shift policy.
Is the Bernanke Fed up to the challenge? It is an interesting situation to say the least.
Wednesday, July 18, 2007
Oil elasticity
Well now we know. In a poll of 524 Americans who identified themselves as members of "an investor class" (your guess is a good as mine) Reuters tells us that 40% of Americans would curtail driving and pare back other discretionary spending with gasoline prices over $3.50 a barrel. Remember that price is a nationwide average price, so depending on where you live, your mileage elasticity may differ.
Agency problem
Investors in Bear Stearns levered and more levered sub-prime hedge funds learned today they face losses of 91% and 100% respectively. With two weeks having passed since the initial margin calls and the ABX indices having only traded steadily lower, this is hardly surprising. In hindsight it should not have been surprising that running futures type leverage on a portfolio of entirely sub-prime junk (even if tranched and prioritized) 18 months into the unraveling of the greatest real estate bubble in history would lead to total losses. Bear itself was not swayed by the opportunity. The firm wagered mere token money in staking the funds at the outset. Yet investment managers gave Bear's funds $1.5bn of other people's money to take exactly that bet. Forget the Bear Letter to Investors, now public. M* wants to see the investor roster. Who pays these guys?
Tuesday, July 17, 2007
Price elasticity revisited
As the gentleman at the counter of the local bodega handed over an even $5 for a gallon of milk this morning, m* wondered about a topic that has been until recently far removed from the minds of most Americans for some time - food price inflation.
The FT on Monday reports that food inflation inChina
I suspect if there is one price elasticity very much appreciated by the average person, it is that for food, and it is close to zero. We can afford just so much muddled bemusement as officials talk about one-time increases and non-core items while pointing to the hedonically adjusted prices for cable television and college textbooks that show inflation to be under control. But when you start spinning that tale on my Pathmark bill, whether you are Bill inIllinois Guangdong
Even if you subscribe, and I do, to the significant marginal pressure on exchange rates coming from central bank portfolio target management, the market is also voting on individual central bank credibility in the face of higher global inflation. The BOE, the RBNZ, and even the 'ole ECB are winning. My bank is currently losing.
The FT on Monday reports that food inflation in
I suspect if there is one price elasticity very much appreciated by the average person, it is that for food, and it is close to zero. We can afford just so much muddled bemusement as officials talk about one-time increases and non-core items while pointing to the hedonically adjusted prices for cable television and college textbooks that show inflation to be under control. But when you start spinning that tale on my Pathmark bill, whether you are Bill in
Even if you subscribe, and I do, to the significant marginal pressure on exchange rates coming from central bank portfolio target management, the market is also voting on individual central bank credibility in the face of higher global inflation. The BOE, the RBNZ, and even the 'ole ECB are winning. My bank is currently losing.
Price elasticity
As m* watches the inexorable rise of dollar priced items apparently not in the official scorekeeper's core consumption basket, a few recent news items brought to mind that the law of supply and demand is not a direct driver of prices but is mediated through a sometimes direct but also sometimes vague transmission known as elasticity.
George Anders page one piece in last week's pre-Murdoch WSJ on Linear Technologies very nicely demonstrates that for small items like a component who's cost makes up just a few percent of the overall cost of a finished product, price elasticity can be quite low. However in a highly competitive marketplace with many substitute products and producers low price elasticity and high profitability is a short lived and highly cyclical moving target.
However in the less competitive marketplace for let's say, industrial commodities, where the supply elasticities are very low and substitutes hard to come by, steadily rising prices (and astronomical profits) have been the norm as globalization and BRIC industrialization kicked into high gear. And yet official policy towards these price increases has been very similar to that of Linear Technologies customers. While the prices for these materials has increased, they make up an increasingly smaller component of our increasingly service based economy and are therefore tolerably inconsequential to our overall price picture.
Which brings us to the second item, Zavier Blas's FT reports on the apparently changing price elasticity for oil. It is now widely understood, if we take the IEA figures as correct, that growth in oil demand of between 1.5% and 2 % annually is outstripping a supply appearing ever more fixed at perhaps 1% on a good day, even as the price continues to march higher. I am reminded of the debate a few years ago as oil first went from the 20's to the 40's and beyond about what price level would induce the SUV loving US consumer to finally curtail the MEW spending binge. Well, we are finally seeing weakness in real retail spending, but given the rather more dramatic pressure of rising home mortgage resets and stagnant or falling home prices (and thus a shift to more expensive revolving consumer credit) I am not sure we can yet pin this on higher oil prices.
I bring this up only because our official scorekeeper does not include the price of oil in its "core" inflation measuring basket and yet, I do not think it is a secret that it's own forecasts for lower inflation going forward are predicated on higher energy prices slowing down the economy (leading to lower energy prices). Ah me, this is the sort of dancing required of a central banker these days to keep the whole mess of plates in the air and still spinning.
Back to elasticities for a minute, a gallon of gasoline inLondon
It is all in the speed of the adjustment of course (that elasticity again) but as you fill up your tank and dip your Amex for another $85 that could easily be, say, $170 consider that CNBC's latest Trillion Dollar survey shows 80% of managers believe the Fed's next move will be a rate cut. I am not saying it wont but I am pretty sure the bet for now is the other way.
George Anders page one piece in last week's pre-Murdoch WSJ on Linear Technologies very nicely demonstrates that for small items like a component who's cost makes up just a few percent of the overall cost of a finished product, price elasticity can be quite low. However in a highly competitive marketplace with many substitute products and producers low price elasticity and high profitability is a short lived and highly cyclical moving target.
However in the less competitive marketplace for let's say, industrial commodities, where the supply elasticities are very low and substitutes hard to come by, steadily rising prices (and astronomical profits) have been the norm as globalization and BRIC industrialization kicked into high gear. And yet official policy towards these price increases has been very similar to that of Linear Technologies customers. While the prices for these materials has increased, they make up an increasingly smaller component of our increasingly service based economy and are therefore tolerably inconsequential to our overall price picture.
Which brings us to the second item, Zavier Blas's FT reports on the apparently changing price elasticity for oil. It is now widely understood, if we take the IEA figures as correct, that growth in oil demand of between 1.5% and 2 % annually is outstripping a supply appearing ever more fixed at perhaps 1% on a good day, even as the price continues to march higher. I am reminded of the debate a few years ago as oil first went from the 20's to the 40's and beyond about what price level would induce the SUV loving US consumer to finally curtail the MEW spending binge. Well, we are finally seeing weakness in real retail spending, but given the rather more dramatic pressure of rising home mortgage resets and stagnant or falling home prices (and thus a shift to more expensive revolving consumer credit) I am not sure we can yet pin this on higher oil prices.
I bring this up only because our official scorekeeper does not include the price of oil in its "core" inflation measuring basket and yet, I do not think it is a secret that it's own forecasts for lower inflation going forward are predicated on higher energy prices slowing down the economy (leading to lower energy prices). Ah me, this is the sort of dancing required of a central banker these days to keep the whole mess of plates in the air and still spinning.
Back to elasticities for a minute, a gallon of gasoline in
It is all in the speed of the adjustment of course (that elasticity again) but as you fill up your tank and dip your Amex for another $85 that could easily be, say, $170 consider that CNBC's latest Trillion Dollar survey shows 80% of managers believe the Fed's next move will be a rate cut. I am not saying it wont but I am pretty sure the bet for now is the other way.
Subscribe to:
Posts (Atom)