As financial conditions tighten, Fed may have to run to stay in place
Seemingly lost in the talk about whether or not the Federal Reserve should ease again is the idea that financial conditions have tightened and the U.S. central bank may have to offer additional stimulus if only to offset that tightening. Writes Goldman Sachs economist Jan Hatzius:
Alongside the slowdown in the real economy, financial conditions have tightened. Our revamped GS Financial Conditions Index has climbed by nearly 50 basis points since March, as credit spreads have widened, equity prices have fallen, and the U.S. dollar has appreciated.
Goldman’s new GS Financial Conditions Index is based on the firm’s simulations with a modified version of the Fed’s FRB/US Model. It includes credit spreads and housing prices and has a closer relationship with subsequent GDP growth than the previous version of the index, the firm says. A 100-basis-point shock to the GSFCI shaves 1-1/5 percent from real GDP growth over the following year. Still, it’s not quite as bad as it sounds:
Some of this tightening is clearly a reflection of the weaker U.S. economic numbers, so we should not ‘double-count’ it as a negative impulse to growth. And some of it has been offset by the fall in oil prices, which has kept the ‘oil-adjusted’ GSFCI from tightening nearly as much.
The intensification of the European crisis as concern about the Greek election and Spanish banking system mounts accounts for up to half of the tighening in the GSFCI since April, Hatzius said. “We estimate this could shave 0.2 to 0.4 percentage points from U.S. GDP growth over the next year.”
Goldman Sachs expects U.S. growth to average slightly less than 2 percent over the next year, with Q1 2013 the weakest quarter at just 1.5 percent “due to the likely fiscal tightening” then.
Talk of a possible rescue of Spain’s banks wafted through global financial markets before the weekend. The “hit” from Europe to U.S. growth could increase or decline, but the risks are “skewed to a worse outcome than our current baseline,” Hatzius said.
Channels of contagion: How the European crisis is hurting Latin America
If anything positive can be said to have come out of the global financial crisis of 2008-2009, it may be that the theory arguing major economies could “decouple” from one another in times of stress was roundly disproved. Now that Europe is the world’s troublesome epicenter, economists are already on the lookout for how ructions there will reverberate elsewhere.
Luis Oganes and his team of Latin America economists at JP Morgan say Europe’s slowdown is already affecting the region – and may continue to do so for some time. The bank this week downgraded its forecasts for Brazilian economic growth this year to 2.1 percent from 2.9 percent, and it sees Colombia’s expansion softening as well. More broadly, it outlined some key ways in which Latin American economies stand to lose from a prolonged crisis in Europe.
Latin America has exhibited an above-unit beta to growth shocks in the U.S. and the euro area over the past decade; resilient U.S. growth until now had offset some of the pressure coming from lower Euro area growth, but U.S. activity is now weakening too.
The European Union is the destination for around 15% of Latin America’s exports – half of the share of exports to the US but more than those to China – but the share varies widely across individual countries.
Ongoing pressure that European banks are facing to shed assets in order to improve their capital ratios is a potential channel of contagion to Latin America that still warrants close monitoring.
Beyond the direct links between Latin America and Europe related to bilateral trade and bank deleveraging, perhaps the most important channel of contagion in the end will be the impact of the European woes on capital flows – both FDI and portfolio inflows.
The increased economic links between Latin America and China also complicates things, since the latter is showing many signs of sputtering as well:
The influence of China on growth dynamics of Latin America has increased significantly in recent years; a 1 percentage-point lower yearly expansion in China is estimated to reduce Latin America’s full-year GDP growth by around 0.2 percentage point, but the beta is much higher for commodity exporters, particularly Brazil.
Ferguson’s fury: Harvard historian decries female welfare recipients
Another panel, another group of rich guys talking about income inequality in America.
That seemed to be a running theme of the Milken Global Conference by the time Tuesday afternoon rolled around in Los Angeles – particularly when the well-known and notably tart Harvard historian Niall Ferguson took to the stage to decry single welfare moms as lazy drags on society.
Ferguson was responding to comments made by Jeff Greene, the billionaire real estate investor and Democrat who lost (badly) a 2010 bid to represent Florida in the Senate.
Greene recalled a single mother with five children he met on the campaign trail. She was fat (“over 300 lbs”) and depended on a welfare check of just over $600 to put food on the table for her kids, once numbering five. But one kid died in a gang fight, another was locked up and two others were involved in gangs and the drug trade, Greene recalled.
“She could barely take care of herself, much less her kids,” he said, resigned to the idea that this unnamed woman would never work or even attempt to work, much less wean herself off welfare.
While Greene was busy commenting on how society needed to change for the sake of those kids and other members of the future workforce, Ferguson cut him short.
Why, he wondered, was Greene letting this lady off the hook? Why doesn’t she get up off her fat lazy butt and get a job?!, he demanded, with his Scottish brogue in full Braveheart mode.
Ferguson has a bit of an identity crisis. First he names two of his books/TV programs after Clarke and Bronowski, so we’re all under no mistake as to who he wants to be twinned with. Second, he omits that he was the recipient of much welfare through his university…where all fees were paid for by the state to those in need (aka welfare).
Is that a bailout in your pocket?
There was an awkward moment of tension at the Milken Global Conference in Los Angeles, when a buysider on one panel asked a Wall Street banker whether he had pocketed taxpayers’ bailout cash.
The tit-for-tat began when several panelists at the “Outlook for M&A” session began griping about the U.S. government’s tax policy, which they said dissuades corporations from bringing overseas profits back home because of punitive taxes.
The panelists – including James Casey, co-head of global debt capital markets for JP Morgan, Anthony Armstrong, an investment banker at Credit Suisse, and Raymond McGuire, global head of corporate and investment banking at Citigroup – predicted that the M&A market might get a big boost if the U.S. were to offer a tax holiday of sorts for repatriated profits.
They also suggested such a move could be a boon for hiring and economic growth: Tilman Fertitta, a panelist who is chairman and CEO of the consumer products company Landry’s, said he would certainly feel the incentive to do more deals and invest more at home if he could bring back his overseas profits without being taxed. He even wondered why Mitt Romney and Barack Obama hadn’t made such a proposal a key point in their election campaigning.
But just before the executives could launch into a profit repatriation samba, another panelist stopped the music.
Maria Boyazny, CEO of distressed debt investing firm MB Global Partners, pointed out that previous government actions that were supposedly intended to spur the economy had only saved Too Big To Fail banks and bolstered the financial industry’s fortunes. (“No offense to anybody on the panel,” she said in that but-I’m-going-to-offend-you-anyway tone.)
In the intervening time, she said, corporate America has only gotten richer by cutting jobs and hoarding capital. She then wondered aloud where all the $700 billion in bailout money and trillions of dollars in Federal Reserve stimulus programs had actually gone.
“We actually didn’t want [a bailout] and gave it back as soon as we could,”
Hence the reason JP Morgan and Goldman Sachs decided to abandon their non-banking status to join the the others in the TBTF group that accesses the fed $$’s for free oops i mean pay you to take $$’s Fed window of “free wealth at the expense of common folk.”
Citi solicits staff donations for its political lobby
Citigroup, the third largest U.S. bank, is actively soliciting donations from its employees for its political action committee (PAC) or fundraising group. In a letter to staff obtained by Reuters, the bank stressed the importance of the upcoming presidential and Congressional elections, urging staff to give to Citi’s PAC. From the letter:
Our Government Affairs team already does a great job promoting our positions on important issues to lawmakers, but there is one thing that each of us can do to enhance their efforts: contribute to Citi’s Political Action Committee (PAC).
Citi PAC is one of the most effective tools we have to amplify the voice of the company in Washington and enhance our profile with lawmakers. The PAC provides the resources to help suport government officials who share our views on key policy objectives and who understand the impact various policy decisions may have on overall economic investment and growth.
Said a Citi spokesperson:
Citi PAC is funded by the voluntary, personal contributions of its employees. The PAC contributes to candidates on both sides of the aisle that support a strong private sector and promote entrepreneurship.
The firm, which was forced to alter its plans to raise dividend payments following weak results from the Federal Reserve’s bank stress tests earlier this month, is also offering some professional incentives for those employees who are willing to open their wallets.
Over the coming weeks and months, we will host a series of briefings, calls and receptions for Citi PAC supporters. For examples(sic.), contributors to Citi PAC will be invited to attend a closed-door, high-level election year briefing with senior Citi executives and nationally renowned political analyst Charlie Cook. Additional details will soon be circulated.
Stocks rally not sustainable: Prudential
Want the recent rally in stocks to last? Don’t count on it, says John Praveen of Prudential Financial. The Dow Jones industrial average is up over 20 percent since September, and has gained 7 percent since the start of the year. But Praveen sees too many headwinds for the boom to continue.
The pace of gains thus far in 2012 is likely to be unsustainable and volatility is likely to remain high as several downside risks remain. These include:
1) Greek risks: The second Greek bailout and debt restructuring deal are likely to be a short-term reprieve, with still high Greek debt/GDP burden and Greek elections due in April. A negative election outcome with no clear mandate and/or a new government reneging on its commitments (to reduce debt) could potentially roil markets.
2) Other euro zone risks: Further debt rating downgrades of euro zone countries and banks; recession in euro zone and the continued negative feedback loop between the high debt burden and economies in recession.
3) Oil price and geopolitical risks: Continued surge in oil prices with simmering Middle East tensions and risk of short-circuiting the global recovery.
Too big to fail banks? Break ‘em up, Fisher says
Dallas Federal Reserve Bank President Richard Fisher wants the biggest U.S. banks broken up, calling them a danger to financial system stability and their perpetuation a drag on the economy. It’s an argument he’s made before – in full-length speeches, asides to reporters, parries to audience questions. (For the latest iteration, see Dallas Fed bank’s annual report published Wednesday.)
Indeed, Fisher is among the most consistent of Fed policymakers. He’s against further quantitative easing – has been ever since QE2, back in 2010. (By contrast, Minneapolis Fed President Narayana Kocherlakota supported QE2, before reversing course and opposing new rounds of monetary easing in 2011 and 2012). He’s against big banks, of course. He says repeatedly that uncertainty over taxes and regulation, not too-high borrowing costs, is what is holding back businesses from investing and hiring.
He’s even consistent with his jokes: several times last year Fisher lampooned the Fed’s increasing emphasis on transparency, quipping that no one wants to see a “full frontal” view of a 100-year-old institution. That particular joke dates back to at least 2006, according to a transcript of a Fed policy-setting meeting from October of that year. “Uncertainty is the enemy of decisionmaking,” Fisher said then, lambasting market participants eager for the Fed to provide more clarity on its views. “Of course they want more frequent forecasts. Governor Kohn and I talked about this before. They want a full frontal view. I find a full frontal view most unbecoming.”
CDS and the self-fulfilling default
Wall Street-made financial instruments purportedly created to protect investors against default actually hasten corporate bankruptcies, according to a new study. And it’s not Occupy protesters bashing these credit default swaps (CDS) – the report comes from none other than the New York Society of Security Analysts. Its findings are as follows:
We present evidence that the probability of credit rating downgrade and the probability of bankruptcy both increase after the inception of CDS trading. […]
Lenders who insure themselves by buying CDS protection help push borrowers into bankruptcy, even though restructuring may be a better choice for the firm from the conventional (without CDS protection) lenders’ perspective.
The problem, say the authors, comes down to a basic conflict of interest – creditors holding the securities suddenly hold an actual stake in the firm’s failure.
CDS could affect bankruptcy risk through two channels associated with the empty creditor problem. The first and direct channel is the effect on the willingness to restructure the debt, whereby creditors (over)insured with CDS break the link between cash flow rights and control rights. Empty creditors are unwilling to restructure the firm even if doing so is efficient for debt value as they can profit significantly from their CDS positions. Several theoretical papers model the empty creditor issue. […]
The second and indirect channel of the empty creditor mechanism is reduced monitoring by creditors who are insured by CDS, and hence, less concerned about the credit risk of the borrower. Absent monitoring activity by creditors, managers can shift risk from shareholders to creditors, since this improves shareholder value, and thereby increases the probability of bankruptcy.
European rescue: Who benefits?
The words “European bailout” normally conjure up images of inefficient public sectors, bloated pensions, corrupt governments. But market analyst John Hussman, in a recent research note cited here by Barry Ritholtz, says the reality is a bit more complicated:
The attempt to rescue distressed European debt by imposing heavy austerity on European people is largely driven by the desire to rescue bank bondholders from losses. Had banks not taken on spectacular amounts of leverage (encouraged by a misguided regulatory environment that required zero capital to be held against sovereign debt), European budget imbalances would have bit far sooner, and would have provoked corrective action years ago.
In other words, even if state actors mishandled government finances, Wall Street was, at the very least, an all-too-willing enabler.
Why banks need (way) more capital
The mantra that regulation is holding back the U.S. economic recovery is playing into Wall Street’s efforts to prevent significant reforms of the financial industry in the wake two major crises – one of which continues to rage in the heart of Europe. The sector’s staunch opposition to reform was captured in JP Morgan’s CEO Jamie Dimon’s claim that new bank rules are “anti-American.”
A new report from the Organization for Economic Cooperation and Development (OECD) suggests the opposition to substantially higher capital requirements is misguided. In particular, economist Patrick Slovik argues that a move away from the Basel accords’ “risk-weighted” approach to capital rules toward a hard-and-fast leverage ratio is the only way to prevent banks from finding creative ways to hide their true risk levels.
When the Basel accords first introduced the calculation of regulatory capital requirements based on risk-weighted assets, it was not expected that for systemically important banks the share of risk-weighted assets in total assets would consequently drop from 70% to 35%. Nor was it expected at the time that the financial system would transform high-risk subprime loans into seemingly low-risk securities on a scale that would spark a global financial crisis. […] Tighter capital requirements based on risk-weighted assets aim to increase the loss-absorption capacity of the banking system, but also increase the incentives of banks to bypass the regulatory framework. New liquidity regulation, notwithstanding its good intentions, is another likely candidate to increase bank incentives to exploit regulation.
In addition, Slovik says market forces can only work properly if regulators debunk the perception that certain firms – like JP Morgan – are considered simply too big to be allowed to fail.
Increasing the capacity of markets to discipline banks will require addressing the too-big-to-fail problem, strengthening and rationalizing bank resolution regimes, and improving bank information disclosures. […] The introduction of a leverage ratio based on non-risk-weighted total assets would help to align banks’ activities with their main economic functions and maximise capital-allocation efficiency. Although a common argument against a stringent leverage ratio is that it would increase bank lending cost and negatively affect the economy, this study has shown that the differences between the macroeconomic impact of risk-weighted and non-risk-weighted regulatory regimes are relatively low.
How are banks able to make the case that higher capital requirements would invariably harm economic growth? In part because of a common misperception about the basic nature of capital, argues Anat Admati, a finance professor at Stanford University’s Graduate School of Business. She says banks use deceptive language – parroted by the financial press – that suggests capital is money that has to be set aside and cannot be lent. This could not be further from the truth, Admati explains. Instead, higher capital requirements would simply force banks to fund themselves with more equity and less debt, thereby making institutions and the financial system much less risky. As she explained in an editorial:
It is critical first to distinguish capital and liquidity requirements. Capital requirements are not about what banks “hold.” They do not mandate that banks passively “set aside,” or “hold in reserve” funds, not putting them to productive uses. Banks’ investments are not constrained by capital requirements. Capital requirements refer only to how banks fund themselves. It is investors, not the banks, who hold the debt and equity (so-called “capital”) claims that banks issue. Liquidity requirements, by contrast, do constrain the types of assets banks hold, and they can be costly. Capital and liquidity requirements refer to different sides of the balance sheet.
