Sunday, August 30, 2009

Monetary policy is upside down.

A massive amount of economic research makes the case that the "high-end" marginal consumer drives a great deal of economic activity in this country. In layman's terms, wealthy people can spend with greater alacrity and abandon than most folks and in an economy where Consumer Spending comprises 70% of GDP, this is a significant slice of demand.

And yet, mainstream economic theory would have us believe that lower interest rates stimulate demand across all economies at all times in history.

(Warning: rhetorical question iminent)

So how, dear reader, does extremely low interest rates effect this demographic, and what are the ramifications to demand from this sudden decrease in current and projected future income among this class?

Lower rates decrease present and future cash flows for net savers of financial assets. This is something that has not been addressed by the Monetarist/Rational Expectations crowd.

Saturday, August 29, 2009

Mission Creep and the Fed

I have written about the foreign currency swap arrangements made by the Fed before. Thankfully, they are decreasing. However, I wanted to point out this testimony by Mr. Bernanke. Pay particular attention to the portion of his testimony wherein he received legal counsel stating that the Fed conducted these swaps under authority of Section 14 of the Federal Reserve Act.

Section 14 of the Federal Reserve Act can be found here. There is no specific power granted to the Fed to conduct swaps or otherwise care about the relative financial positions of foreign central banks. Also, Fed's dual mandate of price stability and economic growth cannot apply to foreign governments.

This activity reminds me immediately of the Maiden Lane situation, where the Fed formed an LLC in order to circumvent restrictions designed to limit outright purchases of assets that are not U.S. obligations. Here, the Fed has not overtly purchased foreign currency, but rather have entered into derivative contracts that are linked to cross currency obligations.

The risk for both situatons is similar: if there is default or an impairment in the ability to pay, the Fed will seize the collateral. In this case, the collateral is currency. While this may not be a problem for relatively stable jurisdictions like the Euro area (and that of course is debateable), for smaller or more volatile jurisdictions (like Mexico) there is a significant risk of total loss, especially considering these swaps were entered into during a global financial crisis.

This is a classic example of mission creep, and powers not explicitly granted by law will be implicitly seized, and active oversight is impossible in hindsight.

Friday, August 28, 2009

Kicking the tires of Maiden Lane

So we know there are these curious entities called "Maiden Lane, I, II, and III", respectively, wherein a rather large amount of taxpayer money has paid for the slightly speculative notion that "toxic waste" assets bought from various banks who needed to sell anything they had in order to remain a going concern represented a wonderful opportunity to save the financial system and in the process make a few bucks for John Q. Public.

I am going to ignore my usual observations regarding the angular momentum of power and its tendency to concentrate - there have been tacit and explicit bailouts dispensed by the Fed, but that is another story.

So let's look under the hood of these entities.

There are three different Maiden Lane companies. I will address the companies in separate posts.

The first, aptly named "Maiden Lane" was, according to the Fed, formed to facilitate the merger between Bear Stearns and JP Morgan. Its financial statements can be found here.

Maiden Lane borrowed $29 Billion from the Fed (a senior loan in priority) and an additional $1 Billion from JP Morgan (a subordinated loan to the Fed's claim) to buy $30 Billion of securities that comprised a portfolio of Bear Stearns assets. The Fed has done this under the auspices of Section 13(3) of the Federal Reserve Act of 1932. Section 13 (3) allows the Fed to discount certain notes under "exigent" circumstances and the status of the Fed as "lender of last resort". Setting up an LLC is a convenient way to sidestep any reluctance by ombudsmen and the like to object to what appears to be an outright purchase of toxic assets.

Since the assets in the portfolio are collateral for the Fed's loan, and Mr. Bernanke does not forsee any losses on these securities (of course, "loss" is a realized accounting event that manifests upon the actual sale of these securities), concerns from nervous taxpayers are misguided.

Unfortunately, Maiden Lane's portfolio has "lost" (the difference between the "fair market" value and the book value of the securities) nearly 10% of the value of its portfolio:

Account name                                                                                    Aug 26, 2009           Net portfolio holdings of Maiden Lane LLC (1)                                                       26,014  Outstanding principal amount of loan extended by the Federal Reserve Bank of New York (2)           28,820 Accrued interest payable to the Federal Reserve Bank of New York (2)                                   362 Outstanding principal amount and accrued interest on loan payable to JPMorgan Chase & Co. (3)        1,227   1. Fair value. Fair value reflects an estimate of the price that would be received upon selling an asset if    the transaction were to be conducted in an orderly market on the measurement date.  Revalued quarterly.     This table reflects valuations as of      June 30, 2009.  Any assets purchased after this valuation date     are initially recorded at cost until their estimated fair value as of the purchase date becomes available. 2. Book value.  This amount was eliminated when preparing the Federal Reserve Bank of New York's statement    of condition consistent with consolidation under generally accepted accounting principles.  Refer to    the note on consolidation accompanying table 10. 3. Book value.  The fair value of these obligations is included in other liabilities and capital in table 1     and in other liabilities and accrued dividends in table 9 and table 10.

But not to worry, we are still in the "accumulation" period wherein the portfolio of assets and their associated interest rate risks are being managed. Any sale of the portolio can only be invested in Treasuries or U.S. Agency securities. Without knowing when and what prices any sales were, its difficult to ascertain wether or not Treasuries or Agencies have become a significant portion of the overall portfolio. The money will be there at the end, and if it somehow comes up short, then the Fed owns the underlying collateral. This makes the loss figures somewhat puzzling in an environment where Agency securities and Treasuries are generally doing quite well.

But what is that collateral? Is it ANY asset in the portfolio (that may include, as stated above, Treasuries and/or Agency Securities) or is it only those securities as that constituted the Bear Stearns portfolio? The specific language states the "Asset Portfolio" is:

mortgage related securities, residential and commercial mortgage loans and associated hedges (Asset Portfolio)

I identify this issue because it is my belief that the Fed will end up owning a significant portion of the collateral once it becomes obvious that full repayment of principal and accrued interest is impossible considering the quality of these assets. There is some indication of the composition of the assets in Maiden Lane, but details are lacking.

From the "cheap seats", this appears to be a game of park the asset, and to buy time until some sort of reflation of the economy (either by organic GDP growth or by more nefarious monetary measures) occurs.

Thus, The Fed has set up a company, provided that company with a loan, had that company pay a bank (JP Morgan) $29 Billion for a portfolio of securities the value of which can charitably said to be "uncertain". These loans were then secured by the assets of the company, which are largely comprised of securities guaranteed by the Fed. The company can sell some of the portfolio, but can only park the proceeds in securities guaranteed by the Fed. The interest payments from the loans are paid to the New York Fed at prime rates, which are set by the Fed.

...all the Kings Horse, and all the Kings men...where oh where is our Alexander?

Thursday, August 27, 2009

No less an "authority"...

...than the New York Times is catching on the Paper Dragon. Article is here.

Generally Accepted Accounting Principles are not generally accepted in China. This is partly because the Chinese have their own accounting rules and partly because rules are for breaking.

And it’s not just that some company owners are trying to confuse the tax authorities. It’s that, when they do so, they end up also confusing themselves.

The gymnastics they do with revenues and costs are so impressive that the Beijing Olympics should have added an event especially for accountants. Markets with developed gray economies, like Italy, are well known for the practice of keeping one set of accounts for the government and another for the owners so they know what’s really going on. Chinese companies often dispense with the second set, hence the confusion. That’s probably true of other “developing gray economies.”

Wednesday, August 26, 2009

Quote of the Day...

"The American Republic will endure until the day Congress discovers that it can bribe the public with the public's money."

-Alexis de Tocqueville

I will refrain from inserting pithy comments regarding the myriad Fed programs, the CBO report recently released, cross subsidies with vehicle manufacturers, the efficiency of Federal Deficit spending, etc.

I will, however, be posting about the Maiden Lane vehicles soon. I have to understand at least one piece of the pie.

Tuesday, August 25, 2009

False dilemma

The decisions made by entire nations in this article are largely illusory, but the Defense Department loves the "Dragon as next greatest enemy" scenario. In any case, the notion that the Paper Dragon will somehow revoke its "financing" to the U.S. and create the domestic demand needed to support its (centrally planned) population should face harsh criticism.

This particular passage is interesting to note:

The trouble is that the Chinese clearly feel they have enough U.S. government bonds. Their great anxiety is that the Obama administration's very lax fiscal policy, plus the Federal Reserve's policy of quantitative easing (in layman's terms, printing money), are going to cause one or both of two things to happen: the price of U.S. bonds could fall and/or the purchasing power of the dollar could fall. Either way the Chinese lose. Their current strategy is to shift their purchases to the short end of the yield curve, buying Treasury bills instead of 10-year bonds. But that doesn't address the currency risk. In a best-selling book titled Currency Wars, Chinese economist Song Hongbing warned that the United States has a bad habit of stiffing its creditors by letting the dollar slide. This, he points out, is what happened to the Japanese in the 1980s. First their currency strengthened against the dollar. Then their economy tanked.
If only this tectonic shift of maturity swapping was true. TIC data (linked on this page) does not support this and shows either steady or slightly falling purchases of U.S. maturities by foreign concerns all across the curve. China has not done anything remotely like revoking the U.S. credit card. And, let us recall that the current account deficit is NOT "Financed" by foreign purchasers of U.S. dollar denominated securities. That is a remnant of the gold standard and is not applicable. The U.S. spends then does NOT need to "get" dollars from Chinese or anyone else in order to deficit spend.

And the "going out strategy" reminds me of another Asian economy buying up real foreign assets such 10% appreciation to infinity golf courses...until those prices crashed as well. A heavily imabalanced fighter will typically lose to a well-rounded opponent, and the Paper Dragon has looked top-heavy for a long time.

Monday, August 17, 2009


The scope of human behavior is a narrow one.

Pope Benedict XVI, in his latest edict entitled "Caritas in Veritate" (Charity in truth) makes a case against the unfettered capitalism that he suggests caused the current crisis.

His solution is, predictably, more concentration of power for governments (and quasi governmental organizations, such as the Vatican) and presumably a larger role for centralized decision making and related appeals to the "common good". Unfortunately, the great body of evidence describing human behavior for the past 3000 years is not kind to this interpretation. There has certainly been a long-standing struggle for power between the state and religion (indeed, much of Western Civilization can be described by events based on this relationship) and The Church is certainly and excellent example of an organization with "very" long time horizons and patience in achieving its goals.

So there is a diagnostic problem (and we will never likely find a satisfactory boolian causal chain of events that describe this economic crisis) as well as a prescriptive problem. But this is definitely an astute move by The Church as the bubble of government will pop...leaving a vacuum that nature so abhors.