Saturday, July 30, 2011

Default: Won’t Happen. Downgrade: Fear Not; Our Best Generals Are In the Field!

Anyway, what’s a rating on US debt mean?

While one might think this topic is far too serious to find humor, let’s start with a quote from the posting “Isn’t it ironic.” It applies to all of us: “I doubt they’ll figure it out until they learn to laugh at themselves.” The posting goes on to say: “The quotes were included because you can’t make this stuff up.” With that introduction let’s look at some news.

This report is from THE WALL STREET JOURNAL (7/29/2011), but similar stories appear on Associated Press’s wire and in other newspapers. The article is entitled “Lending Markets Feeling the Strain.” It’s worth referencing because it contains reports similar to those summarized in the headlines presented below. However, this posting isn’t about the steps being taken by financial institutions. It’s about the downgrade. With all the doom-and-gloom predictions floating around, it’s good to first laugh at ourselves. Let’s start with a laugh.

With that in mind here’s the quote: “In recent days large Wall Street firms that dominate bond trading … have held conference calls to discuss the consequences of a potential default on the markets…..Executives of big banks have spent hours briefing regulators on their plans….In a similar vein, “SIFMA [Securities Industry Financial Markets Association] has told the Federal Reserve and the Treasury about its plans….

The Fed reports, “We expect to be able to give additional guidance to financial institutions when there is greater clarity….” One more for good measure, “The Office of the Comptroller of the Currency, which regulates the nation's largest banks with the Federal Reserve, is working on guidance to address issues arising from a failure to extend the debt ceiling."

Envision the discussions. Regulator to financial institution: We need to be sure you have a plan to conduct your business in an orderly fashion even though we don’t conduct our business in an orderly fashion. Once we figure out what we’re doing (i.e., get clarity) we’ll tell you what we think you should do (i.e., give guidance).

In an exchange like that, at some point someone has to burst out laughing. Unfortunately, it would probably be The Hedged Economist. Thus, in the posting “Who’s Crazy?” The Hedged Economist ruled out starting a bank. Bursting out laughing would be totally inappropriate. Further, someone would probably interpret it as laughing at them. If the regulators think one is laughing at them, one could lose one’s charter or end up regretting one ever had the charter. But, like was said above, “laugh at ourselves.” No one is laughing at anyone. We put well-intentioned, smart people in absurd situations.

Now, let’s get back to what the downgrade risk means.

DATELINE July 27, 2001 (One doesn’t even need events of the days before or after because they’re just more of the same from the perspective of this posting).

Just in, WALL STREET JOURNAL reports from the front!

The battle for financial survival heats up. In “Companies Bracing for U.S. Default,” one observer reports:

“While companies generally expect Washington to resolve the debt-ceiling impasse at the last moment, they are lining up extra sources of financing, and carefully husbanding cash just in case a deal falls through.”

But, “Pain From Debt Impasse Spreads in Markets” confirms not all is going well:

“Worries about the budget impasse in Washington and growing expectations the U.S. will suffer a credit-rating downgrade spread further across financial markets Tuesday.”

New defensive positions are being rapidly constructed. “Money Funds Dial Down Risk” reports on just one such defensive position.

“As European and American policy makers scramble to avert debt crises, money-market mutual funds are reducing risk and boosting their cash holdings in an effort to prepare for a wave of investor redemptions.”

But, fear not. In “Watchdog Sees Financial Weak Spots” our best generals report they’re preparing defenses and are sure they’ll be prepared for the crisis of 2008.

“Federal officials said the U.S. financial system remains vulnerable to shocks and called for better protection in several areas that exacerbated the 2008 financial crisis.”

“The Financial Stability Oversight Council (FSOC), a new body created by last year's Dodd-Frank financial law, said several areas could pose broad risk to the financial system, including a $2.7 trillion short-term funding market used by Wall Street firms and money-market mutual funds. It also warned the U.S. faces risk related to Europe's debt crisis and said U.S. financial institutions need to improve their balance sheets to protect against potential losses.”

They are, however, a bit behind the curve. The repo markets are already showing stress as reported in other stories on defensive positions.

But, FSOC fails to see they may be creating more systemic risk. Financial institutions are pushing back against new regulations, including requirements for banks to hold larger capital reserves. One way to manage reserve requirements is to hold more Treasuries, and to a lesser extent, government agency bonds. The FSOC said the new rules required by the Dodd-Frank law are necessary, and it suggested additional tightening was needed.

Yep, they’re ready for 2008.

Just to add humor I guess, Treasury Secretary Timothy Geithner added that "we must also work to ensure that our regulatory framework keeps pace with the evolving global financial system." But, he’s fighting the last war. Does he realize his Treasury and his irresponsible statements are a big source of the risk to our financial system this time? Doubt the Treasury is a source of the risk? Read on.

One of the markets of concern is the repo market. It’s a concern because it’s about a $4 trillion market that is like plumbing for the U.S. financial system. Why is Geithner concerned? Well, in the repo market, borrowers put up some of the safest securities available as collateral in order to borrow for a very short period, often overnight. As mention the FSOC estimates the short term market at $2.7 and seems to view it as the immediate concern. Treasuries and bonds backed by government agencies are the best collateral.

The collateral is worth more than the amount of the loans. That serves as a form of incentive for borrowers to pay back the loan. The collateral is also protection for the lender against default on the loan. The difference between the value of the collateral and the amount of the cash loans is the "haircut." You may recognize that word since it often came up during the liquidity squeeze of 2008.

The fear is that lenders might demand additional compensation in the form of more collateral for the risk associated with holding Treasuries and agency debt as collateral. That would force borrowers to put up more securities for the same loans. The result would be that banks, hedge funds and investors that rely on debt could be forced to cough up billions of dollars more in collateral.

You say: “Wasn’t better reserves, like Treasuries, what the FSOC was recommending? Aren’t they discussing increasing the collateral required in margin accounts, emphasizing better collateral like more Treasuries?” Well, yes. All those are the right steps for the crisis of 2008. But, this time the battle focuses on Treasury holdings as a source of risk.

Think this folly doesn’t matter? It does. According to Federal Reserve data, Bank of America, Citigroup, J.P. Morgan Chase, Wells Fargo, Goldman Sachs and Morgan Stanley together at the end of the first quarter held $1 trillion in US debt, agency securities and government-backed mortgage bonds. All US commercial banks hold $1.6 trillion. Why? For regulatory capital purposes, US Treasury obligations generally receive a 0% risk weighting, while debt associated with agencies such as Fannie Mae and Freddie Mac are typically at 20%. So, who is out of touch here?

But, you say, “Aren’t people moving to cash? That’s what the reports say.” Well, often the reports include short-run Treasuries in cash although reporters are tightening up their terminology in response to this new crisis. But, cash or money is usually defined along the lines of what economists call M1. That includes demand deposits at banks and dollar bills in circulation. Money market funds and companies are able to go to cash because of a clause in the Dodd-Frank law. The clause provides unlimited FDIC insurance to all funds in non-interest bearing accounts at US-insured institutions. The clause expires on Dec. 31, 2012. Yes, they’re in cash. But, the checking accounts are with the same banks that hold $1 trillion in Treasury and Treasury-backed debt. Does it create a potential liquidity trap? Does it focus reserve management on the asset that is the current source of systemic risk? Yes, to both.

Lest this all seem pessimistic, this Blog in a posting on Thursday, April 1, 2010 entitled: “Beware the risk-free return,” discussed sovereign risk in some detail. It pointed out: “Sovereign entities are not too big to fail. Default isn’t an absolute. There are a lot of ways sovereign risk can be expressed….It doesn’t take a genius to see that a risk-free rate of return is a myth.” We’re just coming to an understanding of that fact. Unfortunately, it might be a hard landing -- a potential hard landing not because it’s suddenly true. Maybe it’s a problem because it’s taking a likely downgrade to force the realization. Perhaps it’s a problem because it was the risk-free-return fiction that facilitated behavior that justifies a downgrade.

All of the steps reported in the dateline from the front are the logical adjustments financial institutions need to take given that there is no risk-free return. Other reports indicate the public is also making the adjustment. If you’re wondering why it’s such a threat, it’s explained in the posting, “Beware the risk-free return.” In the broadest sense, it’s because “much of the intellectual underpinning of modern financial economics has a risk-free cost of capital assumption built in.”

“The concept of a risk-free rate of return is like a cancer that has invaded modern financial economic theory. Usually, Treasury Bills are used as a quantitative expression of the mythical risk-free rate of return. Every time “risk-free” appears in a formula or in print, stop! Ask: ‘What does the author really mean? Are they really saying anything? What concept really should be used? What assumptions have to be made in order for the formula or phrase to make sense?’ All sorts of issues get brushed aside through the simple assumption that risk-free returns are an acceptable substitute for addressing some very volatile behaviors.”

Because so much of the financial system as well as the public have been forced to make the adjustment rapidly, the risk of over shooting is very real. Consequently the volatile behaviors referenced above as brushed aside are made more volatile. Further, they’re all going to surface at once. Other countries have experienced a downgrade from AAA (e.g., Japan in 1998, Australia in 1986, and Canada in 1995), but they weren’t the major reserve currency or the currency used the quote prices for as many commodities. So, the adjustment is much more of a global issue.

The broad acceptance of the fiction of Treasuries as a risk-free return has resulted in many systems built with the assumption hard wired in. They include systems in banks, trading systems, regulatory agencies including the Fed, option pricing models, futures pricing models, etc. Those systems are hastily being “un-hard wired.” There is a high probability someone will mess up and the financial plumbing will break down temporarily. It would seem this would be a bigger risk in the US since other countries, especially in Europe, have systems that already accommodate sovereign debt that no one would ever consider risk free.

That these changes are happening is one threat. The “culture shock” as people abandon one paradigm and adjust to another is another risk. It can freeze people in place or set off volatile behavior in totally unpredictable ways. But, a really big threat arises from the need to make the shift quickly and in a system already under stress. Stress that is arising from regulatory uncertainty and the hangover from the last shift from the housing-prices-always-go-up paradigm. It also doesn’t help that it has taken real concern about default to make the point.

There is also the risk that regulators won’t let financial institutions adjust to the new paradigm; it has costs for the government. They might just keep forcing and encouraging them to hold more Treasuries, the source of the risk. But, ultimately the greatest risk arises from how hard it is to dislodge a good fiction.

Governments and financial markets love a good fiction. But, let’s not dismiss the public. They like fiction too. How many people think the government or a financial advisor can save them from themselves? How many think they can escape the “The Only Truth About Finance?” We may just hang on to a comfortable fiction, deciding it’s easier to go down with the ship than abandon the fiction.

There is another risk. The song “Crazy” starts with, “I remember when, I remember, I remember the day I lost my mind.” Paradigm shifts aren’t easy; some people may find themselves muttering that line, hopefully, in jest. But, more than likely, they won’t feel that the next line fits: “There was something so pleasant about that place.”

Unfortunately, uncertainty is unavoidable; it’s there. It would be tragic if it takes a default, a truly disastrous event, to get people to recognize that fact. Let’s hope the risk-free-rate-of-return nonsense is abandoned without a default. In the short run, the downgrade will be bad enough.

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