PrefBlog

The Bank of Canada has released a working paper by Jean-Sébastien Fontaine and René Garcia titled Bond Liquidity Premia:

Recent asset pricing models of limits to arbitrage emphasize the role of funding conditions faced by financial intermediaries. In the US, the repo market is the key funding market. Then, the premium of on-the-run U.S. Treasury bonds should share a common component with risk premia in other markets. This observation leads to the following identification strategy. We measure the value of funding liquidity from the cross-section of on-the-run premia by adding a liquidity factor to an arbitrage-free term structure model. As predicted, we find that funding liquidity explains the cross-section of risk premia. An increase in the value of liquidity predicts lower risk premia for on-the run and off-the-run bonds but higher risk premia on LIBOR loans, swap contracts and corporate bonds. Moreover, the impact is large and pervasive through crisis and normal times. We check the interpretation of the liquidity factor. It varies with transaction costs, S&P500 valuation ratios and aggregate uncertainty. More importantly, the liquidity factor varies with narrow measures of monetary aggregates and measures of bank reserves. Overall, the results suggest that different securities serve, in part, and to varying degrees, to fulfill investors’ uncertain future needs for cash depending on the ability of intermediaries to provide immediacy.

As far as corporates are concerned, they suggest:

Finally, we consider a sample of corporate bond spreads from the NAIC. We find that the impact of liquidity is significant and follows a flight-to-quality pattern across ratings. For bonds of the highest credit quality, spreads decrease, on average, following a shock to the funding liquidity factor. In contrast, spreads of bonds with lower ratings increase. We also compute excess returns on AAA, AA, A, BBB and High Yield Merrill Lynch corporate bond indices (see Figure 3) and reach similar conclusions. Bonds with high credit ratings were perceived to be liquid substitutes to government securities and offered lower risk premium following increases of the liquidity factor. This corresponds to an average effect through our sample, the recent events suggests that this is not always the case.

Corporate spreads are dealt with in more detail:

The impact of funding liquidity extends to the corporate bond market. This section measures the impact of the liquidity factor on the risk premium offered by corporate bonds. Empirically, we find that the impact of liquidity has a flight-to-quality” pattern across credit ratings. Following an increase of the liquidity factor, excess returns decrease for the higher ratings but increase for the lower ratings. Our results are consistent with the evidence that default risk cannot rationalize corporate spreads. Collin-Dufresne et al. (2001) find that most of the variations of non-default corporate spreads are driven by a single latent factor. We formally link this factor with funding risk. Our evidence is also consistent with the differential impact of liquidity across ratings found by Ericsson and Renault (2006). However, while they relate bond spreads to bond-specific measures of liquidity, we document the impact of an aggregate factor in the compensation for illiquidity.
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First, as expected, average excess returns are higher for lower ratings. Next, estimates of the liquidity coefficients show that the impact of a rising liquidity factor is negative for the higher ratings and becomes positive for lower ratings. A one-standard deviation shock to the liquidity factor leads to decreases in excess returns for AAA, AA and A ratings but to increases in excess returns for BBB and HY ratings. Excess returns decrease by 2.27% for AAA index but increase by 2.38% for the HY index. For comparison, the impact on Treasury bonds with 7 and 10 years to maturity was -4.52% and -5.42%. Thus, on average, high quality bonds were considered substitutes, albeit imperfect, to U.S. Treasuries as a hedge against variations in funding conditions. On the other hand, lower-rated bonds were exposed to funding market shocks.

However, in extreme cases the sign of the relationship for hiqh quality bonds changes:

Adding 2008 only increases the measured impact of the common funding liquidity factor on bond risk premia. Each of the regression above leads to higher estimate for the liquidity coefficient. An interesting case, though, is the behavior of corporate bond spreads. Clearly corporate bond spreads increased sharply over that period, indicating an increase in expected returns. What is interesting is that this was the case for any ratings. Figure 8 compares the liquidity factor with the spread of the AAA and BBB Merrill Lynch index. In the sample excluding 2008, the estimated average impact a shock to funding liquidity was negative for AAA bonds and positive for BBB. The large and positively correlated shock in 2008 reverses this conclusion for AAA bonds. But note that AAA spreads and the liquidity factor were also positively correlated in 1998. This confirms our conjecture that the behavior of high-rating bonds is not stable and depends on the nature or the size of the shock to funding liquidity. Note that this does not affect our conclusion that corporate bond liquidity premium shares a component with other risk premium due to funding risk. Instead, it suggests that the relationship exhibits regimes through time.

I recently highlighted some KC Fed research on monetary policy that concluded that Fed policy was too loose in the period 2001-05.

Now, David Papell, Professor of Economics at University of Houston writes a guest-post for Econbrowser titled Lessons from the 1970s for Fed Policy Today that discusses many of the same issues.

He brings to my attention a speech by John Taylor himself, presented at a FRB Atlanta conference:

One view is that “the markets did it.” The crisis was due to forces emanating from the market economy which the government did not control, either because it did not have the power to do so, or because it chose not to. This view sees systemic risk as a market failure that can and must be dealt with by government actions and interventions; it naturally leads to proposals for increased government powers. Indeed, this view of the crisis is held by those government officials who are making such proposals.

The other view is that “the government did it.” The crisis was due more to forces emanating from government, and in the case of the United States, mainly the federal government. This is the view implied by my empirical research and that of others. According to this view federal government actions and interventions caused, prolonged, and worsened the financial crisis. There is little evidence that these forces are abating, and indeed they may be getting worse. Hence, this view sees government as the more serious systemic risk in the financial system; it leads in a different direction—to proposals to limit the powers of government and the harm it can do.

Dr. Taylor takes the opportunity to tout his new book, Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, Hoover Press, Stanford, California, 2009, and why not?

I argue that the primary initial cause was the excessive monetary ease by the Fed in which the federal funds rate was held very low in the 2002-2005 period, compared to what had worked well in the past two decades. Clearly such an action should be considered systemic in that the entire financial system and the macro economy are affected. My empirical work shows that these low interest rates led to the acceleration of the housing boom and to the increased use of adjustable rate mortgages and other risk-increasing searches for yield. The boom then resulted in the bust, with delinquencies, foreclosures, and toxic assets on the balance sheet of financial institutions in the United States and other countries.
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The questions about the role of government in the crisis go well beyond the initial impetus of monetary policy. The gigantic government sponsored enterprises, Fannie and Freddie, fueled the flames of the housing boom and encouraged risk taking—chain reaction style—as they supported the mortgage-backed securities market. Moreover these agencies were asked by government to purchase securities backed by higher risk mortgages. Here I have no disagreement with Alan Greenspan and others who tried to rein in these agencies at the time.
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… in my view the problem was not the failure to bail out Lehman Brothers but rather the failure of the government to articulate a clear predictable strategy for lending and intervening into a financial sector. This strategy could have been put forth in the weeks after the Bear Stearns rescue, but was not. Instead market participants were led to guess what the government would do in other similar situations. The best evidence for the lack of a strategy was the confusing roll out of the TARP plan, which, according to event studies of spreads in the interbank market, was a more likely reason for the panic than the failure to intervene with Lehman.

Assiduous Readers will remember that on November 12 I referenced previous predictions that TARP (the asset-buying part) would fail for the same reason that MLEC failed. Shamed by PrefBlog’s criticism, Paulson abandoned the idea that day. The latest resurrection of this old zombie is the Public-Private Partnership Fund which has attracted the usual roster of well-connected firms and so far looks like a fizzle.

Back to Dr. Taylor:

Some argue that the reason banks have been holding off and demanding a higher price for their toxic assets than the market is offering is the expectation that federal funds will be forthcoming to assist private purchases. If so, this may be an explanation for the freezing up of some markets and the long delay in the recovery of the credit markets.
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But mistakes occur in all markets and they do not normally become systemic. In each of these cases there was a tendency for government actions to convert non-systemic risks into systemic risks. The low interest rates led to rapidly rising housing prices with very low delinquency and foreclosure rates, which likely confused both underwriters and the rating agencies. The failure to regulate adequately entities that were supposed to be, and thought to be, regulated certainly encouraged the excesses. Risky conduits connected to regulated banks were allowed by regulators. The SEC was to regulate broker-dealers, but its skill base was in investor protection rather than prudential regulation. Similarly, the Office of Thrift Supervision (OTS) was not up to the job of regulating the complex financial products division of AIG. These regulatory gaps and overlapping responsibilities added to the problem and they need to be addressed in regulatory reform.

Going forward, he sees reckless government spending as being the number one systemic risk:

To understand the size of the risk, consider what it would take to balance the budget in 2019? Income tax revenues are expected to be about $2 trillion, so with a deficit of $1.2 trillion, a 60 percent tax increase across the board would be required. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP? Inflation will do it. But how much inflation? To bring the debt to GDP ratio down to the level at the end of 2008, it will take a doubling of the price level. That one hundred percent increase will make nominal GDP twice as high and thus cut the debt to GDP ratio in half, back to about 40 from around 80 percent. A hundred percent increase in the price level means about 10 percent inflation for 10 years. And it is unlikely that it will be smooth. More likely it will be like the 1970s with boom followed by bust with increasingly high inflation after each bust. This is not a forecast, because policy can change; rather it is an indication of the systemic risk that the government is now creating.

A second systemic risk is the Fed’s balance sheet. Reserve balances at the Fed have increased 100 fold since last September, from $8 billion to around $800 billion, and with current plans to expand asset purchases it could rise to over $3,000 billion by the end of this year. While Federal Reserve officials say that they will be able to sell the newly acquired assets at a sufficient rate to prevent these reserves from igniting inflation, they or their successors may face political difficulty in doing so. That raises doubts and therefore risks. The risk is systemic because of the economy-wide harm such an outcome would cause.
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The Fed’s calculation reported in the Financial Times has both the sign and the decimal point wrong. In contrast my calculation implies that we may not have as much time before the Fed has to remove excess reserves and raise the rate. We don’t know what will happen in the future, but there is a risk here and it is a systemic risk.
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In my view the increasing number of interventions by the federal government into the operations of private business firms represents a systemic risk. The interventions are also becoming more intrusive and seemingly capricious whether they are about employee compensation, the priority of debt holders, or the CEO. Many of these actions reverse previous government decisions, and they involve ex post changes in contracts or unusual interpretations of the law. We risk losing the most important ingredient to the success of our economy since America’s founding—the rule of law, which will certainly be systemic.

It does my heart good to hear somebody talk about “the rule of law” and mean it. In most people’s mouths it means “Crack down on people I don’t like.”

David Papell concluded his post on Econbrowser with the warning:

In the 1970s, the Fed “stabilized” overly optimistic inflation forecasts and responded too strongly to output gaps, lowering interest rates too much — especially during and following the 1970-1971 and 1974-1975 recessions, resulting in frequent recessions and the Great Inflation. What are the lessons from the 1970s for Fed policy today?

• •The Fed should respond to inflation, not inflation forecasts, especially in an environment where large negative output gaps are causing forecasted inflation to fall.
• •The Fed should not tinker with Taylor’s output gap coefficient of 0.5.

Using the rule with Taylor’s original coefficients, the experience of the 1970s suggests that, even if it could, the Fed should not lower its interest rate target below zero. If the incipient recovery takes hold and inflation stays the same or rises, it may need to raise rates sooner than many people think.

The Kansas City Fed has published an article by Roberto Billi (one of their economists) with the title Was Monetary Policy Optimal During Past Deflation Scares?.

This essay is considered TOP SECRET and the PDF has therefore been copy-protected (jerks!), so there won’t be a lot of extracts posted here.

Mr. Billi uses the Taylor Rule as a measure of monetary policy effectiveness and explains the model and its parameterization in good detail. He uses an inflation response parameter equal to one, providing an appendix to justify this choice … but according to me, this appendix needs a great deal more fleshing out!

He then examines Japanese monetary policy during their deflationary episode of the 1990’s and concludes that monetary policy was too tight. Then he examines US monetary policy and – with the benefit of hindsight – finds that Fed policy in 2000 was too tight; during 2001-03 the fed funds rate was on average 100bp low; during 2004-05, it was 175bp too low. He explains that the discrepency is “mainly due to a substantial wedge between Greenbook forecasts and revised inflation, and to a lesser extent to the effects of the data revisions on the estimate of the output gap”.

TEN magazine is a house organ of the Kansas City Fed (which runs the tenth Federal Reserve District … get it?).

The newly released edition contains articles regarding:

• Community banks say competition for customers in rural America is increasing, especially from the federally chartered Farm Credit System. Banks say there is an unfair advantage; the Farm Credit System says choices benefit consumers. Read more in the fall issue of TEN.

Also in the new issue:

• A look at the home foreclosure crisis now as it spreads to higher-income
  neighborhoods;

• A breakdown of how regions in the United States are affected by the most recent
  recession and what causes the variances;

• A few words from Kansas City Fed President Tom Hoenig on expanding the Fed’s role in the payments system;
• Tips and free activities and resources by TEN columnist Michele Wulff for talking to kids about smart spending; and more.

The Bank for International Settlements has released its Report on Special Purpose Entitites. Section I is the Executive Summary & Overview:

Section II provides a summary of market developments that contributed to the growth of the securitisation markets that relied heavily on the use of SPEs. Also described is the confluence of factors that played a part in the market crisis that began in mid-2007.

Section III focuses on the motivations of sponsoring firms and investors for employing SPEs. For originators and sponsors, these may include risk management, funding, accounting, or regulatory capital considerations.

Section IV describes the potential for informational asymmetries and problematic incentives to hamper the use of SPEs, examines potential issues and deficiencies in risk management, and explores ways in which risk transfer can potentially be over- or underestimated by both originators and investors.

Section V presents a series of policy issues and recommendations for consideration.

Appendix 1 is a primer on common types of SPE structures and programs, such as RMBS, CMBS, CDOs, ABCP conduits, structured investment vehicles (SIVs), repackaging vehicles, and transformer structures.

Appendix 2 continues with a more technical discussion of common features of SPEs. Legal forms, methods of achieving asset transfer, and accounting and regulatory capital considerations are discussed. Additionally, the roles of key parties to SPEs (eg the sponsor, originator, and servicer) are described, as well as issues related to the control and management of these entities.

Appendix 3 explores how the risk and return of assets in SPEs can be allocated among various parties and counterparties. Different forms of exposure can result from holding certain tranches and residual interests or from providing liquidity and credit guarantees. This section also includes a discussion of triggers, where the cash flows are redirected should a particular event occur.

Appendix 4 provides global data on the use of SPEs by financial institutions according to vehicle type and geography.

Appendix 5 provides the list of members of the Joint Forum Working Group on Risk Assessment and Capital.

The International Monetary Fund has released the (prelimary version of) the Global Financial Stability Report, October 2009, with three chapters:

• The Road to Recovery
• Restarting Securitization Markets: Policy Proposals and Pitfalls
• Market Interventions during the Financial Crisis: How Effective and How to Disengage?

I was happy to see the following in the Executive Summary:

But hard work lies ahead in devising capital penalties, insurance premiums, supervisory and resolution regimes, and competition policies to ensure that no institution is believed to be “too big to fail.” Early guidance at defining criteria for identifying systemically important institutions and markets—such as that being formulated by the International Monetary Fund, Financial Stability Board, and Bank for International Settlements for the G-20—should assist in this quest. Once identified, some form of surcharge or disincentive for marginal contributions to systemic risk will need to be formulated and applied.

A surcharge is infinitely preferable to flat prohibitions and Treasury’s special regime. The report repeatedly warns about “cliff effects” in the securitization market; such cliff effects are a sign of incompetent analysis; prohibitions and special regimes bring about cliff effects by their nature.

They produce an amazing chart decomposing credit spreads that I have trouble taking seriously:

There are no references cited for this decomposition. While I have great respect for IMF research and am sure they didn’t just pluck the numbers out of the air, it’s quite hard enough to decompose spreads into credit risk & liquidity (see, for example, The Value of Liquidity), without adding other factors.

As if on purpose to reinforce my skepticism regarding connections between premises and conclusions, they publish an amazing regression analysis in the section titled “Will bank earnings be robust enough to absorb writedowns and rebuild capital cushions?”:

… with the comment:

To protect bottom line earnings, banks appear to have priced risky lending more expensively—as shown by the upward sloping trend line for European banks in Figure 1.10.

I think they’re trying too hard. Presented by the G-20 with a golden opportunity to expand their bureaucracy – after ten years of looking irrelevance in the face – I suspect that management has sent the word out to come up with the BEST conclusions and the BEST analysis and the BEST policy recommendations right away (for “best”, read “best looking”). Anybody who’s ever read a sell-side economic commentary will be very familiar with this paradigm.

The term-shortening of bank financing was of interest:

We won’t be out of the woods until the term structure of bank liabilities returns to normal.

The second chapter provides a very good overview of securitization.

The Boston Fed has released a Public Policy Discussion Paper by Daniel Cooper titled Did Easy Credit Lead to Economic Peril? Home Equity Borrowing and Household Behavior in the Early 2000s, which dispels at least part of the notion that Americans went insane earlier this decade and spent their home equity loans on beer and prostitutes:

Using data from the Panel Study of Income Dynamics, this paper examines how households’ home equity extraction during 2001‐to‐2003 and 2003‐to‐2005 affected their spending and saving behavior. The results show that a one‐dollar increase in equity extraction led to ninetyfive or ninety‐eight cents higher consumption expenditures. Nearly all of this spending increase was reversed in the subsequent period. A fair amount of these expenditures went toward home improvements and repairs. In addition, households used home equity to help finance their purchases of used cars. Equity extraction also led to some household balance sheet reshuffling. In particular, households who extracted equity were somewhat more likely than other households to pay down their higher‐cost credit card debt and to invest in other real estate and businesses. Overall, the results in this paper are consistent with households’ extracting equity during the first half of this decade to fund one‐time durable good consumption needs.

The author concludes, in part:

Overall, the results suggest that households’ reasons for borrowing against their homes have changed little over time. Households who have lower levels of financial wealth are more likely to extract equity as are households who experience strong local or regional house-price growth. In addition, the consumption analysis suggests that households borrowed against their homes in the early 2000s, to finance one-time consumption shocks. A one-dollar increase in equity extraction led to a roughly ninety-five cent increase in consumption between 2001 and 2003, which did not persist over time. In particular, consumption fell by roughly the same amount in the period ( 2003-to-2005) following the period when households extracted equity.

Additional analysis suggests that households extract equity for one-time, durable goods purchases. Roughly a quarter of each dollar of equity extraction goes toward home repairs and improvements, consistent with anecdotal evidence. Households also extract equity, for used car purchases. There is limited evidence, however, that households’ (non-durable) food purchases increase when they borrow against their homes. The findings also show that households have a roughly 10 percentage point higher predicted probability of paying down their non-collateralized debt when they extract equity than when they do not. Homeowners are also slightly more likely to invest in other real estate or personal businesses when they borrow against their houses. As a result, equity extraction has household balance sheet effects in addition to the effect of households’ borrowing to fund their one-time consumption needs.

The analysis in this paper does not cover the final years of the recent house-price boom, since the PSID data are available only through 2005.

So, while in hindsight it is obvious that American households became over-leveraged during the early part of the housing boom, it is something of a relief to learn that the money was spent on durable goods rather than immediate consumption.

Update, 2009-10-1: The Bank of Canada has released a related study by Ian Christensen, Paul Corrigan, Caterina Mendicino and Shin-Ichi Nishiyama titled Consumption, Housing Collateral, and the Canadian Business Cycle:

Using Bayesian methods, we estimate a small open economy model in which consumers face limits to credit determined by the value of their housing stock. The purpose of this paper is to quantify the role of collateralized household debt in the Canadian business cycle. Our findings show that the presence of borrowing constraints improves the performance of the model in terms of overall goodness of fit. In particular, the presence of housing collateral generates a positive correlation between consumption and house prices. Finally we find that housing collateral induced spillovers account for a large share of consumption growth during the housing market boom-bust cycle of the late 1980s.

The Investment Industry Association of Canada has released its Securities Industry Performance Report, 2Q09: fixed income trading was highlighted:

Particularly strong was debt underwriting which witnessed a 54% surge in revenue from the previous quarter as narrowing spreads made debt financings more alluring for issuers. Fixed-income principal trading revenue was also robust and totaled $640 million in the second quarter, a record high, and represented a 15% increase from the prior quarter. For the first half of 2009, industry fixed income revenues (debt underwriting plus debt principal trading) total $1.5 billion and already equal the total for the whole of 2008.

Gee, I sure hope nobody gets a bonus because of this surge in gross profit! Paying for performance can lead to … er … something bad.

There’s not enough data in the report even to make a good guess at the reason for the surge in trading revenue, but it seems probable that the desks have made profits for the same reason that my fund’s returns have been so good over the past year: lots of panic, lots of volatility, lots of players who really don’t have a clue.

The Federal Reserve Bank of Cleveland has released the September 2009 Edition of EconoTrends, with short articles on:

• July Price Statistics
• The Yield Curve, August 2009
• The Changing Composition of the Fed’s Balance Sheet
• Borrow Less, Owe More: The U.S. Net International Investment Position
• Real GDP: Second-Quarter 2009 Revised Estimate
• Recent Forecasts of Government Debt
• The Incidence and Duration of Unemployment over the Business Cycle
• The Employment Situation, August 2009
• Fourth District Employment Conditions
• Bank Lending, Capital, Booms, and Busts

The last is under the general heading “Baking and Financial Institutions”, so I guess we’re cooked!

The next chart shows a source of our current problems that many consider more important that pesky bankers’ bonuses: