An Autopsy for the Keynesians

We were warned that the 2013 sequester meant a recession. Instead, unemployment came down faster than expected.

By John H. Cochrane

Dec. 21, 2014 6:42 p.m. ET


Russian Roulette: Taxpayers Could Be On The Hook For Trillions In Oil Derivatives

The sudden dramatic collapse in the price of oil appears to be an act of geopolitical warfare against Russia. The result could be trillions of dollars in oil derivative losses; and the FDIC could be liable, following repeal of key portions of the Dodd-Frank Act last weekend.

Senator Elizabeth Warren charged Citigroup (NYSE:C) last week with "holding government funding hostage to ram through its government bailout provision." At issue was a section in the omnibus budget bill repealing the Lincoln Amendment to the Dodd-Frank Act, which protected depositor funds by requiring the largest banks to push out a portion of their derivatives business into non-FDIC-insured subsidiaries.

Warren and Representative Maxine Waters came close to killing the spending bill because of this provision. But the tide turned, according to Waters, when not only Jamie Dimon, CEO of JPMorgan Chase (NYSE:JPM), but President Obama himself lobbied lawmakers to vote for the bill.

It was not only a notable about-face for the president, but represented an apparent shift in position for the banks. Before Jamie Dimon intervened, it had been reported that the bailout provision was not a big deal for the banks and that they were not lobbying heavily for it, because it covered only a small portion of their derivatives. As explained in Time:
The best argument for not freaking out about the repeal of the Lincoln Amendment is that it wasn't nearly as strong as its drafters intended it to be... [W]hile the Lincoln Amendment was intended to lasso all risky instruments, by the time all was said and done, it really only applied to about 5% of the derivatives activity of banks like Bank of America (NYSE:BAC), Citigroup, JPMorgan Chase, and Wells Fargo (NYSE:WFC), according to a 2012 Fitch report.
Quibbling over a mere 5% of the derivatives business sounds like much ado about nothing, but Jamie Dimon and the president evidently didn't think so. Why?

A Closer Look at the Lincoln Amendment

The preamble to the Dodd-Frank Act claims "to protect the American taxpayer by ending bailouts." But it does this through "bail-in": authorizing "systemically important" too-big-to-fail banks to expropriate the assets of their creditors, including depositors. Under the Lincoln Amendment, however, FDIC-insured banks were not allowed to put depositor funds at risk for their bets on derivatives, with certain broad exceptions.

In an article posted on December 10th titled, "Banks Get To Use Taxpayer Money For Derivative Speculation," Chriss W. Street explained the amendment like this:
Starting in 2013, federally insured banks would be prohibited from directly engaging in derivative transactions not specifically hedging (1) lending risks, (2) interest rate volatility, and (3) cushion against credit defaults. The "push-out rule" sought to force banks to move their speculative trading into non-federally insured subsidiaries. 
The Federal Reserve and Office of the Comptroller of the Currency in 2013 allowed a two-year delay on the condition that banks take steps to move swaps to subsidiaries that don't benefit from federal deposit insurance or borrowing directly from the Fed. 
The rule would have impacted the $280 trillion in derivatives primarily held by the "too-big-to-fail (TBTF) banks that include JPMorgan Chase, Bank of America,  
Citigroup, and Wells Fargo. Although 95% of TBTF derivative holdings are exempt as legitimate lending hedges, leveraging cheap money from the U.S. Federal Reserve into $10 trillion of derivative speculation is one of the TBTF banks' most profitable business activities.
What was and was not included in the exemption was explained by Steve Shaefer in a June 2012 article in Forbes. According to Fitch Ratings, interest rate, currency, gold/silver, credit derivatives referencing investment-grade securities, and hedges were permissible activities within an insured depositary institution. Those not permitted included "equity, some credit and most commodity derivatives." Schaefer wrote:
For Goldman Sachs and Morgan Stanley, the rule is almost a non-event, as they already conduct derivatives activity outside of their bank subsidiaries. (Which makes sense, since neither actually had commercial banking operations of any significant substance until converting into bank holding companies during the 2008 crisis). 
The impact on Bank of America, Citigroup, JPMorgan Chase, and to a lesser extent, Wells Fargo, would be greater, but still rather middling, as the size and scope of the restricted activities is but a fraction of these firms' overall derivative operations.
A fraction, but a critical fraction, as it included the banks' bets on commodities. Five percent of $280 trillion is $14 trillion in derivatives exposure - close to the size of the existing federal debt.

And as financial blogger Michael Snyder points out, $3.9 trillion of this speculation is on the price of commodities.

Among the banks' most important commodities bets are oil derivatives. An oil derivative typically involves an oil producer who wants to lock in the price at a future date, and a counterparty - typically a bank - willing to pay that price in exchange for the opportunity to earn additional profits if the price goes above the contract rate. The downside is that the bank has to make up the loss if the price drops.

As Snyder observes, the recent drop in the price of oil by over $50 a barrel - a drop of nearly 50% since June - was completely unanticipated and outside the predictions covered by the banks' computer models. The drop could cost the big banks trillions of dollars in losses. And with the repeal of the Lincoln Amendment, taxpayers could be picking up the bill.

When Markets Cannot Be Manipulated

Interest rate swaps compose 82% of the derivatives market. Interest rates are predictable and can be controlled, since the Federal Reserve sets the prime rate. The Fed's mandate includes maintaining the stability of the banking system, which means protecting the interests of the largest banks. The Fed obliged after the 2008 credit crisis by dropping the prime rate nearly to zero, a major windfall for the derivatives banks - and a major loss for their counterparties, including state and local governments.

Manipulating markets anywhere is illegal - unless you are a central bank or a federal government, in which case you can apparently do it with impunity.

In this case, the shocking $50 drop in the price of oil was not due merely to the forces of supply and demand, which are predictable and can be hedged against. According to an article by Larry Elliott in the UK Guardian titled, "Stakes Are High as US Plays the Oil Card Against Iran and Russia," the unanticipated drop was an act of geopolitical warfare administered by the Saudis. History, he says, is repeating itself:
The fourfold increase in oil prices triggered by the embargo on exports organised by Saudi Arabia in response to the Yom Kippur war in 1973 showed how crude could be used as a diplomatic and economic weapon.
Now, says Elliott, the oil card is being played to force prices lower:
John Kerry, the US secretary of state, allegedly struck a deal with King Abdullah in September under which the Saudis would sell crude at below the prevailing market price. That would help explain why the price has been falling at a time when, given the turmoil in Iraq and Syria caused by Islamic State, it would normally have been rising. 
...[A]ccording to Middle East specialists, the Saudis want to put pressure on Iran and to force Moscow to weaken its support for the Assad regime in Syria.

 War on the Ruble

If the plan was to break the ruble, it worked. The ruble has dropped by more than 60% against the dollar since January.

On December 16th, the Russian central bank counterattacked by raising interest rates to 17% in order to stem "capital flight" - the dumping of rubles on the currency markets. Deposits are less likely to be withdrawn and exchanged for dollars if they are earning a high rate of return.

The move was also a short squeeze on the short sellers attempting to crash the ruble. Short sellers sell currency they don't have, forcing down the price; then cover by buying at the lower price, pocketing the difference. But the short squeeze worked only briefly, as trading in the ruble was quickly suspended, allowing short sellers to cover their bets. Who has the power to shut down a currency exchange? One suspects that more than mere speculation was at work.

Protecting Our Money from Wall Street Gambling

The short sellers were saved, but the derivatives banks will still get killed if oil prices don't go back up soon. At least they would have been killed before the bailout ban was lifted. Now, it seems, that burden could fall on depositors and taxpayers. Did the Obama administration make a deal with the big derivatives banks to save them from Kerry's clandestine economic warfare at taxpayers' expense?

Whatever happened behind closed doors, we the people could again be stuck with the tab. We will continue to be at the mercy of the biggest banks until depository banking is separated from speculative investment banking. Reinstating the Glass-Steagall Act is supported not only by Elizabeth Warren and others on the left, but by prominent voices such as David Stockman's on the right.

Another alternative for protecting our funds from Wall Street gambling can be done at the local level.

Our state and local governments can establish publicly-owned banks; and our monies, public and private, can be moved into them.

The Outlook

As Fed Shines Light on Shadow Banking, Its Regulatory Limits Get Laid Bare

Central Bank Faces Hurdles as Officials Look to Stamp Out Potential Problems in Financial System

By Pedro Nicolaci da Costa and Ryan Tracy

Dec. 21, 2014 3:28 p.m. ET

As Federal Reserve officials ramp up their efforts to monitor and curb risky activities by financial firms outside the banking system, a key question is emerging: What can they do about any problems they find?

The so-called shadow-banking system is growing again in the U.S. after declining from 2008 through 2011 in the wake of the financial crisis. The value of U.S. financial assets held by money-market funds, hedge funds, trust companies and financial firms other than banks reached $25.2 trillion in 2013, for the first time exceeding the precrisis peak of $24.9 trillion, according to a November report by the Financial Stability Board, an international body of regulators.

U.S. shadow-banking assets accounted for about one-third of the global total of $75.2 trillion in 2013, which was up from $70.5 trillion the year before. And in the U.S., shadow banking is bigger than the more tightly regulated traditional banking system, which according to the FSB had $20.2 trillion in assets as of 2013.

The burgeoning numbers are giving financial regulators around the world an urgency to get a handle on shadow banking before history repeats itself with another crisis.

Fed officials recall that many roots of the financial crisis lay in the shadow-banking world, for example with nonbank lenders making subprime mortgage loans to risky borrowers, financial firms then bundling the debt into securities, and insurers pledging to cover the risk of default on the securities. In a July speech recounting lessons from the crisis, Fed Chairwoman Janet Yellen said “key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, weak underwriting of loans, deficiencies in risk measurement and risk management, and the use of exotic financial instruments that redistributed risk in nontransparent ways.”

The Fed board’s new three-member committee on financial stability, led by Vice Chairman Stanley Fischer , is focusing on shadow-banking issues. One of the panel’s chief challenges is that the Fed was created as a banking regulator and has limited powers to monitor or influence other types of firms. And while other federal regulatory agencies have authority over many nonbank financial activities, blind spots remain.

“No U.S. agency yet has access to complete data regarding bank and nonbank financial activities,” Fed governor Lael Brainard, a member of the committee, said in a speech earlier this month.

Ms. Brainard, outlining how the Fed is trying to overcome these hurdles, said the central bank has increased its surveillance efforts by assessing “financial vulnerabilities”—such as high valuations and high levels of borrowing by households and businesses—in a variety of asset classes. The central bank also is working with other U.S. and foreign agencies to share data.

A next step is for Mr. Fischer’s committee to figure out what the Fed can do about any risks it identifies outside the banking system.

Aside from the gray area about its authority to oversee nonbank financial firms, the Fed lacks some “macroprudential” regulatory and supervisory tools used by other central banks in recent years. Such macroprudential measures aim to maintain the stability of the whole financial system, in contrast with “microprudential” efforts to ensure the soundness of individual institutions.

The Fed, for example, can’t impose limits on loan-to-value ratios for home or business loans, as some other central banks have done. In his former post as governor of the Bank of Israel, Mr. Fischer used regulatory policies to try to slow credit growth in the housing market—including raising minimum down payments for mortgages—with what he has said was mixed success.

Fed policy makers could raise interest rates to rein in excessive borrowing, but they view that as a blunt instrument that could damp growth across the economy rather than address specific problems. Ms. Yellen and other officials have said they view rate increases specifically aimed at asset bubbles and other risky behavior as a second line of defense of financial stability, to be used only after more targeted measures fail.

But the Fed’s macroprudential tool kit isn’t empty. It could adopt capital requirements that rise when bubbles start to form, leaning against risk-taking when regulators believe it has become excessive. It could also raise required levels of equity needed to fund investments in particular sectors, like corporate debt or real estate. Fed officials have cited the bank stress-test process as a way to not only check the health of banks but remedy any shortcomings they encounter.

Another approach could be regulation of so-called securities-financing transactions that help fund a lot of shadow-banking activity. Ms. Brainard cited the Fed’s authority to require participants to hold a minimum amount of extra collateral at the margin, regardless of whether a bank or other party is executing the transactions.

In the end, it’s unclear how effective such measures will be, and Ms. Brainard and other Fed officials have said that at times they might need to turn to interest-rate increases to do the job.

Fear And Loathing In Precious Metals

  • Bulls and bears - fear and greed.
  • Deflation loathes industrial precious metals.
  • Bipolar metals.
  • A down year in gold?
  • "A word to the wise is infuriating."
I write a lot on the precious metals markets these days. In my most recent piece for Seeking Alpha, Gold And Silver: Physical Demand is a Signal that Prospects Are Looking Up, I pointed to the excellent demand in silver and gold from a variety of locations around the globe.

However, each time I think I have figured out the next move for the precious metals, I learn that trying to understand these markets is virtually impossible. After that bullish article was published, precious metal prices moved lower.

Bulls and bears - fear and greed

Fear and greed drives all markets to some degree. Gold and silver are no exception. I have been trying to figure out, or at least explain, why these metals do what they do since I started trading them in 1983. I had a great vantage point, better than most. I ran one of the largest trading desks for an international bullion dealer and member of the London Bullion Market Association. I bought and sold gold with Central Banks and Supranational institutions around the globe. I even took some of the biggest precious metals positions in history, but I still find it difficult to explain why these metals do what they do. The best answer as to why the price of anything goes up is that there are more buyers than sellers and vice versa. It is the "wisdom of crowds" principle, and the market price is always the correct price at any moment in time.

Throughout history, precious metals have been a means of exchange -a currency. In modern times, they are barometers of fear. They go to levels where investors and speculators get greedy, and then they reverse. In recent weeks, they have been quiet. It is hard to figure in a world dominated by headline news that is less than settling why these metals have not reacted.

One thing that I have learned is that there are two camps in the world of precious metals. The camps are analogous to hard-core right-wing conservatives and left-wing liberals in US politics.

So dug in are their positions according to their ideology that they explain every event and every circumstance, spinning it with ideological vigor. Gold bulls point to easy monetary policies, they explain down moves as manipulation. Bears point to these metals as barbarous relics of a day-long past. Both camps make excellent arguments. The question becomes, what events trigger the crowd, the addressable market of investment professionals, speculators and individuals to adopt their point of view? Additionally, once adopted how long does it last?

As the year 2014 draws to a close I believe that both camps, precious metals bull and bears (particularly in gold), lost money this year. After riding a bull market that took gold from under $300 an ounce in 2001 to the highs of over $1900 in 2011, it is easy to understand why.

Those who stuck with gold in 2008 when it dropped from the then all-time highs, of over $1030 to under $700 were handsomely rewarded as the rally continued reaching even greater heights.

The same is true for silver. For those who are still long and lost money this year, it is greed - even though they may hold the same opinion as to the value of the metals, the fact is that these commodities moved lower in dollar terms in 2014 and they have lost value. For those who trade gold and silver on occasions, higher equity prices, a stronger dollar and the prospect of higher interest rates have not created the aura of fear necessary to bring them back to gold and silver.

Deflation loathes industrial precious metals

Commodity prices have dropped in 2014. With few exceptions, the asset class has suffered loss of value. Grains plunged as good weather created bumper crops, sending prices to the lowest level in years. The price of what is probably the most political and ubiquitously traded commodity, crude oil, has almost halved over the past six months. Iron ore, coal, copper and many other commodity prices have gone south. There is a host of reasons. Economic weakness in Europe, sluggish growth in China and a dollar that has rallied have been negative factors for commodity prices.

The current perceived strength in the US economy will eventually lead to higher interest rates. Gold and silver (as well as other commodities) trade in dollars, thus higher interest rates raise the cost of carry - a negative factor. The world has become a smaller place due to technology; what happens in other countries affects the US economy. Given the current state of affairs around the globe, the potential for contagion is a negative factor. All of this adds up to a deflationary scenario, and commodity price action in 2014 reflects those fears.

The prices of platinum and palladium are excellent examples of the fear of deflation that now permeates markets. Both markets are in deficit. The vast majority of palladium production comes from Russia, as a byproduct of nickel in Siberia. Palladium prices are higher on the year only due to the current issues surrounding Russia and Mr. Putin. Platinum prices are lower on the year. This is after a five-month strike at platinum mines in South Africa, the country that produces the lion's share of world supplies. The price of platinum is at or below production cost for many South African producers.

Fears of deflation explain lower commodity prices. When it comes to precious metals, investment demand is always what drives price. Given prospects for deflation, investment demand is just not at levels that will support higher prices, at least for now. Investors are loathing commodities and precious metals.

Bipolar metals

I believe that when it comes to understanding commodity prices, the nominal price you see on the screen is a one-dimensional picture. In order to establish true value, one must look at other substitutable commodities to understand historical value. Historical value is important because history tends to repeat itself. Patterns are not always the same, sometimes they bend a bit but we can glean a tremendous amount in terms of value from this discipline.

In 2014, we have seen a huge divergence from historical norms when it comes to precious metals. It has been a bipolar year for this sector of the commodity market. Over the past forty years, the price of platinum has traded as low as a $200 discount to gold - that was in the wake of the financial crisis in 2008 and during a global recession. Prior to the downturn, platinum traded to a high of over a $1,100 premium to its yellow cousin. Platinum is ten times as rare as gold and it has a host of industrial applications. As I write this piece, platinum and gold are trading at the same exact price. Given historical price action, this leads me to believe that currently either platinum is too cheap or gold is too expensive.

The other bipolar relationship is that between silver and gold. Silver prices moved lower in 2014. At the beginning of the year, there were around 61 ounces of silver value in each ounce of gold value. This is the silver-gold ratio. Over the past forty years, the average for this relationship was 55:1. Over the course of this year, the relationship has extended to where it currently is around 75:1. As in platinum, given the historical trading pattern, either silver is too cheap or gold is too expensive given current price levels.

Given action in the precious metals sector in 2014, bipolar trading levels currently exist.

A down year in gold?

While gold is currently expensive relative to platinum and silver, it is still lower than it was at the beginning of the year. As of the close on Friday, December 19, gold is down around 3.6% on the year, in dollar terms. Therefore, it is not that the gold price has been so strong, rather that the prices of its precious cousins, silver and platinum, are so weak. However, I would argue that given overall market sentiment in 2014, gold has performed very well. Gold analysts examine the price of gold in dollars, why not? That is the international medium for gold. It is the price most people around the globe watch - gold in dollars.

Consider the Russian who holds some gold these days. The ruble has moved from 33-1 against the dollar at the beginning of 2014 to over 60-1. For that investor, gold is not down on the year; it is up big in rubles - a godsend to the Russian with the presence of mind to protect wealth. That is an extreme example.

Let us look at gold in euros. Gold in euros closed on December 31, 2013 at 874 euros per ounce. As of the close of business Friday, December 19, gold in euros trades at 977 euros per ounce.

Gold in euro terms has appreciated by just under 12% in 2014.

Is it a down year in gold? I guess that depends on where you stand.

"A word to the wise is infuriating"

Fear and loathing in the precious metals markets, as those of you who have read Hunter S. Thompson are keenly aware, is a title I pilfered from the late author, as is the quote above. It is a great title that explains so much about human emotion and drive. Whether it is fear and greed or fear and loathing, the precious metals have a little of both going on. On a historical basis, we have seen divergence in this sector extend over the course of the year. As the year draws to a close, these inter-commodity relationships have extended to the widest levels of the year.

A word to the wise for the precious metals bulls and bears out there -expect the unexpected in 2015. The inter-commodity spreads between gold and its precious cousins are telling us something important. Either gold is too expensive, or silver and platinum are too cheap on a historical basis.

You can trade that! Each camp has great arguments. The bulls will say that the printing presses in the US that ran nonstop for years have a price down the road - inflation. Now the printing presses in Europe are gearing up to do the same thing. Fiat currency is intrinsically worthless. The bears will counter that the current global economic condition is a path to continued deflation. Deflation will deflate the value of everything, including precious metals.

The bulls fear, the bears loath. I am afraid that for both camps, my word to the wise will be nothing more than infuriating. As I wrote at the beginning of this treatise, what do I know? I've only been trading these metals for 32 years.