Yellen Unveiling, Jackson Hole 2016

Doug Nolan

The Global Financial Crisis and Great Recession posed daunting new challenges for central banks around the world and spurred innovations in the design, implementation, and communication of monetary policy. With the U.S. economy now nearing the Federal Reserve's statutory goals of maximum employment and price stability, this conference provides a timely opportunity to consider how the lessons we learned are likely to influence the conduct of monetary policy in the future. The theme of the conference, ‘Designing Resilient Monetary Policy Frameworks for the Future,’ encompasses many aspects of monetary policy, from the nitty-gritty details of implementing policy in financial markets to broader questions about how policy affects the economy.” The introduction to Janet Yellen’s speech, “The Federal Reserve's Monetary Policy Toolkit: Past, Present, and Future,” Jackson Hole, August 26, 2016

Bloomberg: “Yellen Says Rate-Hike Case ‘Strengthened in Recent Months.’” The FT was almost identical to Bloomberg. It was hardly different at the WSJ: “Fed Chairwoman Janet Yellen Sees Stronger Case for Interest-Rate Increase.” And from CNBC: “Yellen says a rate hike is coming—but markets say not now.” And this from Zerohedge: “Best Reaction Yet: ‘Yellen Speech A Whole Lot Of Nothing.’”

I have a different take: Yellen provided more content for history books. In today’s short-term focused world, analysts and pundits remain fixated on clues to the next policy move. And while Yellen included language unbecoming of ultra-dovishness for the near-term, the Fed chair’s presentation was zany-dovish for the intermediate- and longer-term.

The Yellen Fed has begun methodically laying the analytical foundation for a Federal Reserve (and global central banks) balance sheet of unthinkable dimensions. It’s right there in her writing, as explicit as it is astounding. Before it’s too late, the Fed’s power – and their runaway policy experiment – need to be reined in. Contemporary Central bankers have been operating with blank checkbooks only because it was never contemplated that they would actually exploit their capacity to print “money” with reckless abandon. Who cannot see that these central bankers need clear rules and well-defined restraints? Their judgment is not trustworthy.

The WSJ’s Jon Hilsenrath penned an interesting pre-Jackson Hole piece, “Years of Fed Missteps Fueled Disillusion With the Economy and Washington.” “Once-revered central bank failed to foresee the crisis and has struggled in its aftermath, fostering the rise of populism and distrust of institutions. In the past decade Federal Reserve officials have been flummoxed by a housing bubble that cratered the financial system, a long stretch of slow growth they failed to foresee and inflation persistently undershooting their goal. In response they engineered unpopular financial rescues, launched start-and-stop bond buying and delayed planned interest-rate boosts. ‘There are a lot of things that we thought we knew that haven’t turned out quite as we expected,’ said Eric Rosengren, president of the Federal Reserve Bank of Boston. ‘The economy and financial markets are not as stable as we previously assumed.’”

Yellen’s above speech introduction refers to “lessons we learned.” It is, however, rather obvious that the Federal Reserve has completely failed to recognize how a flawed monetary policy framework was fundamental to a financial Bubble that collapsed into the “worst financial crisis since the Great Depression.”

This year’s Jackson Hole summit is to consider “broader questions about how policy affects the economy.” What’s conspicuously absent from Yellen’s (and others’) analytical framework is the extraordinary impact policy continues to play in the securities and derivatives markets – and over time through the markets into the overall economic structure.

Over the years I’ve detailed how the GSEs, acting as quasi-central banks, in the early nineties began backstopping market liquidity. Having ended 1993 at $1.9 TN, GSE securities (debt and MBS) in just ten years more than tripled to $6.0 TN. Revelations of serious accounting fraud at Fannie and Freddie ended their capacity for “buyer of first and last resort” liquidity support.

I argued at the time that going forward only the Fed would retain the wherewithal to engineer market liquidity backstop operations to counter a serious de-risking/de-leveraging episode, though this would require a major expansion of Fed’s holdings. The mortgage finance Bubble inflated much longer and to far greater excess than I had expected, which ensured that its bursting triggered a historic Trillion plus doubling of Fed holdings. Later, in 2011 the Fed detailed its “exit strategy”, yet proceeded to again double assets to $4.5 TN.

I have posited that the Fed’s balance sheet is likely on course to reach $10 Trillion. This rough guesstimate stems from the view that there is no alternative to the Fed’s balance sheet for future liquidity backstop operations. Moreover, the unprecedented inflation of Bubble excess (securities and asset markets, economic maladjustment) ensures that only another doubling of the Fed’s balance sheet could possibly hold financial collapse at bay.

In the simulations reported by Reifschneider, ‘Gauging the Ability of the FOMC to Respond to Future Recessions,’ in note 8, overcoming the effects of the zero lower bound during a severe recession would require about $4 trillion in asset purchases and pledging to stay low for even longer if the average future level of the federal funds rate is only 2 percent.

The above zinger is footnote #24 embedded in Yellen’s speech. And the Fed chair’s inflationist reasoning culminates with her focus on Fed staffer David Reifschneider’s recent paper (cited above). The gist of the analysis is that if the Fed lacks the typical capacity to slash interest rates, policy can compensate with more aggressive asset purchases and forward rate guidance. Undoubtedly, the Fed will face minimal rate flexibility the next time it employs further monetary stimulus. So get ready. Bonds seem ready.

From Yellen: “
A recent paper takes a different approach to assessing the FOMC's ability to respond to future recessions by using simulations of the FRB/US model. This analysis begins by asking how the economy would respond to a set of highly adverse shocks if policymakers followed a fairly aggressive policy rule, hypothetically assuming that they can cut the federal funds rate without limit. It then imposes the zero lower bound and asks whether some combination of forward guidance and asset purchases would be sufficient to generate economic conditions at least as good as those that occur under the hypothetical unconstrained policy.

Figure 2 in your handout illustrates this point. It shows simulated paths for interest rates, the unemployment rate, and inflation under three different monetary policy responses--the aggressive rule in the absence of the zero lower bound constraint, the constrained aggressive rule, and the constrained aggressive rule combined with $2 trillion in asset purchases and guidance that the federal funds rate will depart from the rule by staying lower for longer…

But despite the lower bound, asset purchases and forward guidance can push long-term interest rates even lower on average than in the unconstrained case (especially when adjusted for inflation) by reducing term premiums and increasing the downward pressure on the expected average value of future short-term interest rates. Thus, the use of such tools could result in even better outcomes for unemployment and inflation on average.

Of course, this analysis could be too optimistic. For one, the FRB/US simulations may overstate the effectiveness of forward guidance and asset purchases, particularly in an environment where long-term interest rates are also likely to be unusually low. In addition, policymakers could have less ability to cut short-term interest rates in the future than the simulations assume. By some calculations, the real neutral rate is currently close to zero, and it could remain at this low level if we were to continue to see slow productivity growth and high global saving. If so, then the average level of the nominal federal funds rate down the road might turn out to be only 2 percent, implying that asset purchases and forward guidance might have to be pushed to extremes to compensate
… (footnote 24)”

If a 2% Fed funds rate equates to $4.0 TN of Fed purchases, what about 1%? How about 50 bps? Using the Fed’s own framework, a $10 TN Federal Reserve balance sheet no longer seems all that “lunatic fringe.”

Of course, chair Yellen is not about to espouse the stunningly audacious without the obligatory tinge of caution: “Moreover, relying too heavily on these nontraditional tools could have unintended consequences. For example, if future policymakers responded to a severe recession by announcing their intention to keep the federal funds rate near zero for a very long time after the economy had substantially recovered and followed through on that guidance, then they might inadvertently encourage excessive risk-taking and so undermine financial stability.”

My comment: “…Future policymakers… might inadvertently encourage excessive risk-taking and so undermine financial stability.” You think?? Might it be worthwhile contemplating the past and current?

Finally, the simulation analysis certainly overstates the FOMC's current ability to respond to a recession, given that there is little scope to cut the federal funds rate at the moment. But that does not mean that the Federal Reserve would be unable to provide appreciable accommodation should the ongoing expansion falter in the near term. In addition to taking the federal funds rate back down to nearly zero, the FOMC could resume asset purchases and announce its intention to keep the federal funds rate at this level until conditions had improved markedly--although with long-term interest rates already quite low, the net stimulus that would result might be somewhat reduced.”

If markets are willing to cooperate, the Fed may bump up rates 25 bps in September. Friday evening from the WSJ’s Heard on the Street column: “Janet Yellen Cries Wolf - Fed chairwoman tries to convince market that a rate rise is coming, but investors aren’t listening.”

Could it be instead that they listened intently and came away even more persuaded? Perhaps the WSJ (and others) is missing the point: it’s not about crying wolf or a lack of credibility with respect to rate hikes. After all, a second little baby-step would be trivial in the context of rising odds of a Fed balance sheet on its way to ballooning to $10 TN. Global bond markets continue to trade as if there’s a very credible threat of monstrous QE/central bank purchases to eternity. 

And the greater the scope of the world’s most spectacular asset Bubble, the higher the odds that central bankers will be forced into even more preposterous desperate measures – aka ever larger QE purchases of a widening variety of securities.

Somehow the Fed completely disregards the prominent role loose monetary policy has played in inflating serial financial and economic Bubbles. It gets worse. Revisionism somehow has Yellen expounding analysis that policy was “tight” heading into the 2008 crisis period. Mortgage debt doubled in less than seven years, for heaven’s sake. Unprecedented leverage, speculative excess and financial shenanigans…

From Yellen: “…The federal funds rate at the start of the past seven recessions was appreciably above the level consistent with the economy operating at potential in the longer run. In most cases, this tighter-than-normal stance of policy before the recession appears to have reflected some combination of initially higher-than-normal labor utilization and elevated inflation pressures. As a result, a large portion of the rate cuts that subsequently occurred during these recessions represented the undoing of the earlier tight stance of monetary policy.”

We’re now eight years into history’s greatest monetary stimulus. Global markets have deteriorated to Desolate Bizarro World. After a respite, some volatility has begun to creep back into the markets. It appeared to be another tough week for the leveraged speculator crowd. 

Some favored shorts significantly outperformed. Periphery Europe was a lovefest. Spanish equities jumped 2.5%. Italian stocks surged 3.3%, led by the banking sector’s almost 10% melt-up. European banks stocks jumped 4.9%. Financials outperformed in the U.S. as well, with the banks up 1.1% and the broker/dealers gaining 1.3%. Utilities and dividend stocks underperformed.

A negative tone is gaining momentum in Asia. Intrigue is returning to China, with policymakers gearing up for yet another shot at curbing Bubbles (bonds, real estate, shadow banking, etc.) and general financial excess. The Shanghai Composite dropped 1.2% this week. 

The Nikkei 225 index dropped 1.1%, with Japanese banks losing 1.7%. Stocks were down 1.0% in India and 1.3% in Turkey. Generally, instability reemerged in EM and commodities. The South African rand was slammed for 6.3%. The Brazilian real and Mexican peso dropped about 2%, while a list of EM currencies declined about 1% (Russia, Turkey, Singapore, Colombia, Chile). Brazil’s equities were slammed 2.5% and Mexico’s stocks dropped 1.9%. In commodities, copper sank 4.3% and silver fell 3.5%. The soft commodities were under heavy selling pressure as well.

The U.S. dollar index rallied 1% this week. It was as if Fed officials were determined to don hawkish-like garb hoping to draw attention away from Yellen’s QE Eternity Unveiling. I’ve expected currency market stability to be a leading (observable) casualty of heightened global monetary disorder. Over recent months a short squeeze in EM currencies morphed into a dysfunctional trend-following and performance-chasing fracas. This type of dynamic tends to reverse abruptly and, often, dramatically.

Meanwhile, developed currencies oscillate sporadically, as perceptions swing between perpetual king dollar and the prospect of permanent Fed-induced dollar devaluation. A similar dynamic is behind the return of wild commodities trading. Natural gas surged 11% this week. 

Everyone’s favorite currency short, the British pound, was the only major currency this week to appreciate versus the dollar. Going forward, it will be interesting to see how Bubble markets attempt to reconcile a short-term Fed rate increase versus the Federal Reserve committing itself to boundless QE.

A wake-up call for markets’ infrastructure dreamers

COLOMBO, SRI LANKA - OCTOBER 15: A Chinese laborer works at a construction site at the hotel complex construct by Chinese company on October 15, 2015 in Colombo, Sri Lanka. Sri Lankan new government under the President Maithripal Srisena administration has temporarily suspended China funding US$ 1.4 billion Colombo Port City Project (CPCP) and unhurried support for some China projects. The Colombo Port City Project has been temporarily suspended by government on 6th of March 2015 which was launched by the previous government of President Mhainda Rajapaksa. China has funded many infrastructure projects during Rajapaksa governing period. (Photo by Buddhika Weerasinghe/Getty Images)©Getty

It starts with a wobbling tower of wooden blocks, train track laid end to end, sticks and stones to dam a stream. It is an instinct that leads to grand designs and mega-projects.

The same impulse also explains, perhaps, why infrastructure is becoming investors’ favourite answer to every current problem. Is this nostalgia for a can-do time? We should match Victorian mastery of sewerage, or Eisenhower’s interstate system to connect a vast country, enduring physical legacies of public Works.
Desperate for growth? Just look at the Chinese miracle, a modern economy wrought from concrete and steel in two short decades, entire cities built from scratch.

In the developed world, money for building becomes investment or stimulus rather than everyday spending, a way to sidestep the politics of austerity. Infrastructure, in the abstract, has the attraction of the simple grand plan.

Indeed, it is one of the few policies on which the candidates in November’s presidential election agree, differing only in the size of their ambition. Hillary Clinton intends $275bn of investment over five years, while Donald Trump has talked of a trillion dollars’ worth, not counting a border wall — for that, the bill goes to Mexico.
For pension funds, helping the world to build also offers hope, of the chance to buy assets that will accrue profits reliably in the decades ahead. Investing in long-dated government debt, as is traditional, may not provide the income to meet promises to retirees because bond yields around the world have dropped to record lows.

Yet big ideas tend to gloss over troubling details. Building an airport, bridge or water treatment plant can create a project ready-made for the financial and legal gift-wrap that allows it to be sold to investors, such as pension funds.
What developed countries need, however, tends to be improvements to what exists, the more boring business of resurfacing, widening or repainting. The US federal government spent $46bn on roads in 2014, a quarter of US public spending on highways, and the non-partisan Congressional Budget Office argues the economic benefits of new tarmac have diminished over time, increasing the importance of maintenance instead.
Special-purpose vehicles to raise funding — and the bankers, accountants and lawyers who create them — are also redundant when the cost of borrowing is so cheap. A worldwide collapse in bond yields is sign investors are falling over themselves to fund any and all public spending, so it would be odd for a government to choose to pay more.

Infrastructure branded bonds would be an easy sell, but then what bond is hard to sell today?
Indeed, if direct and explicit financing of government spending by central banks appears to be the logical extension of quantitative easing programmes, claiming it’s to fund long-term investment may be a way to sell the policy to a public wary of so-called money printing.
There will, of course, still be opportunities to invest in ownership of long-lived fixed assets such as pipelines and toll roads. The point is that while infrastructure investment may be a neat thing for a consultant to suggest to one pension fund looking for ideas, the nature of markets means the value of a good idea is diluted the further it’s shared.

For instance, the Canadian Pension Plan has put money into infrastructure since 2005, and as of March it had C$21bn invested, or about 8 per cent of the scheme’s assets. Investment returns have been pretty good, averaging 10 per cent annually since 2007, the first year they were disclosed. It is also cost-effective, with running costs for the infrastructure team last year amounting to just 30 basis points of the capital invested, less than many stockpicking mutual funds.

Such performance does not go unnoticed, however. The pension fund describes intense competition for limited numbers of infrastructure assets, as new investors pile in: “the deals that did materialise were priced high”, said this year’s annual report.
At heart, struggling pension funds face a world where economic growth and inflation are weaker than expected, less than the assumptions built into the architecture of retirement schemes. A desire to pay for new landmarks on the horizon is just the latest way to restate what long-term investors want and need: growth, activity, investment.

martes, agosto 30, 2016



Rising LIBOR

SECular shift

New money-market regulations are pushing up a benchmark interest rate

DURING the financial crisis of 2008, LIBOR was a gauge of fear. The London inter-bank offered rate—at which banks are willing to lend to one another—leapt. (Even then it may have been too reassuring: banks have since been fined billions, and traders jailed, for rigging it.)

Lately it has been climbing again: on August 22nd three-month dollar LIBOR rose above 0.82%. That is no cause for panic, but it is a seven-year high and 0.2 percentage points more than in June. What’s going on?

Increases in LIBOR, a benchmark used to set rates for trillions of dollars’ worth of loans, usually reflect either strains on banks or expected rises in central banks’ policy rates. Although the Federal Reserve has been toying with tightening, this time LIBOR’s ascent has another explanation, traceable to the turmoil of 2008. A change by the Securities and Exchange Commission (SEC) in the regulation of American money-market funds has made borrowing pricier, especially for foreign banks.

Before the crisis investors in money-market funds—which lend for short periods to banks, other companies and the government—had become accustomed to treating their accounts like bank deposits, putting money in and taking it out at will. That changed the day after Lehman Brothers went bust, when the Reserve Primary Fund “broke the buck”, declaring that investors could no longer redeem shares for the customary $1 apiece. A run on funds ensued; to halt the chaos, the Treasury was forced to guarantee them.

The SEC’s new rule, which takes effect on October 14th, obliges “prime” funds (buyers of banks’ and companies’ paper, as well as public debt) serving institutional investors to let their net asset values vary, rather than fix them at $1 a share. To prevent runs, they may also limit and charge for redemptions if less than 30% of their assets can be liquidated inside a week.

This has made prime funds much less attractive, causing a “change in the landscape of the wholesale funds market”, says Steve Kang, an interest-rate strategist at Citigroup. Between October 2015 and July 2016 all prime funds’ assets declined by more than $550 billion, to $1.2 trillion, according to the SEC; “government” funds that invest in Treasuries and the like have swollen by a similar amount, to $1.6 trillion (see chart). Prime funds have also pushed their liquidity ratios well above the 30% threshold as the October deadline approaches; they are loth to lend for as long as three months.

Steven Zeng of Deutsche Bank notes that in the past couple of months the average maturity of large funds’ assets has declined from more than 20 days to less than 13.

For foreign banks, which account for more than $800 billion of prime funds’ $938 billion of bank securities, this is depleting an important source of dollars. (American banks rely more on deposits.)

Borrowing has become pricier, which LIBOR echoes. They seem to be filling the gap: for example, cash-rich companies are thought to be lending via “separately managed accounts” rather than prime funds. Banks have other alternatives, but borrowing using exchange-rate swaps, explains Mr Kang, is more expensive; central-bank swap lines are dearer still, and because they are primarily regarded as emergency facilities, banks are reluctant to tap them.

The pain will vary from bank to bank. American lenders with lots of LIBOR-linked mortgages may even gain. Some foreign banks may also recoup higher borrowing costs: their floating interest-rate commercial loans outweigh those at fixed rates. But many borrowers will pay a price. The aftershocks of 2008 rumble on.

martes, agosto 30, 2016




To have and to hold

The endowment effect among stockmarket investors

ADAM SMITH remarked that no dog ever made a free and fair exchange of one bone for another. Many pooch-owners will agree, having spent frustrating minutes trying to wrestle a stick or a ball off their pets.

But humans are supposed to be rational. They should not value things they own more highly just because they already possess them. Experiments in the classroom have shown, however, that people may be subject to this trait, dubbed the “endowment effect”. In a classic study, students were randomly given a mug. Those who received the mugs were asked what price they would sell them for; the mean was $5.78. Those who did not were asked what they would buy them for; the average was $2.21.

In a similar test, students were asked to state their preference between a mug and a chocolate bar; 56% favoured the former and 44% the latter. Two other groups of students were then randomly assigned the mug or the chocolate and then asked whether they were willing to swap; in each case, around nine in ten of the students were unwilling to do so. You might say they were “possessed”.

That is the kind of result that gets behavioural economists excited, since it suggests people are not the rational calculating machines (Homo economicus) that standard models assume them to be. Traditional economists, by contrast, are sniffy about such experiments, arguing that they bear little relation to the kind of decisions made in the real world.

But a new paper* claims to spot the endowment effect at work among a supposedly hard-headed group of individuals: stockmarket investors. It looks at the flotations—initial public offerings, or IPOs—of companies on the Indian market.

When Indian IPOs are oversubscribed, issuers often use a lottery to assign shares to eager investors. Winning investors are allocated shares at the flotation price; losing investors can buy only after the issue starts trading.

In theory, both groups should be equally keen to own the shares. After all, they applied on the same basis. But the authors found that 62.4% of winners were still holding the shares after a month, while just 1% of losers had bought them. Now, these groups will have paid different prices, since the losers have to buy in the secondary market; the average IPO increases in price by 52% on the first day of trading. On the surface, it makes perfect sense that the losers would not want to pay what they perceive to be an inflated price.

However, if this were the driving force, you would expect to find more losers buying IPOs when the initial gain was small or when prices fell. But the authors found no relationship between the endowment effect and early price movements.

Furthermore, in cash terms, IPO investors’ trading gains are limited. In order to apply for shares, investors have to put an average of around $1,750 into an escrow account, but are allotted shares worth only around one-eighth of that. That means the average first-day trading gain is just $62. Would this really drive such a big difference in behaviour?

Another puzzle is that, after its initial gain, the average IPO falls in price as time goes on; after 12 months, it is 54% below the issue price. So it would make sense for the lottery winners to offload their holdings after the first day’s trading and for the losers to try to buy the stock on the cheap later.

But that doesn’t happen: after a year 45.8% of the winners are still hanging on to their stock, whereas only 1.7% of the losers have piled in.

Perhaps inertia is the driving factor? Investors simply might not get around to trading. But the authors reject that explanation; the endowment effect is still present when they study investors who make more than 20 other stockmarket trades in the month of the IPO.

Another possibility is that those winners who hold onto their shares are naive investors; more experienced traders are more rational. So the authors looked at investors who had taken part in more than 30 IPOs, and found there was still a substantial endowment effect; winners were four times more likely than losers to hold shares at the end of the first month.

It looks, therefore, as if the act of winning the IPO lottery makes investors more willing to hold on to their shares, regardless of their profit or loss. So next time your dog refuses to give up his ball—the very ball he expects you to throw for him to fetch—show him some sympathy. He is only imitating his human owner.

* “Endowment Effects in the Field: Evidence from India’s IPO Lotteries”, by Santosh Anagol, Vimal Balasubramaniam and Tarun Ramodorai.

The hidden pipes of finance may be furring up

JPMorgan’s pullout of tri-party repo market shows impact of banks reshaping their business models

Gillian Tett .

A decade ago JPMorgan Chase looked like a financial octopus: its tentacles reached into almost every part of the Wall Street money machine. But some of those tentacles are now being trimmed.

Take the tri-party repurchase (repo) market — the corner of modern finance where banks and others raise short-term loans backed by collateral while entities such as mutual funds use it to park their cash.

Until now, JPMorgan has been a linchpin of this $1.6tn sector, since it settled and cleared these deals, acting as a bridge between clients. Its only rival was the mighty Bank of New York Mellon. But a couple of weeks ago JPMorgan bankers revealed that they plan to withdraw from this market by the end of 2017 to focus on more profitable activities. This leaves the crucial tri-party repo sector almost exclusively in the hands of Bony; John Pierpont Morgan might be spinning in his grave.
Nobody outside Wall Street has yet paid much attention. To most people the tri-party repo sector is akin to household plumbing — deeply unglamorous and easy to ignore unless the system breaks down and creates a mess.

But, just like plumbing, it matters a great deal whether or not tri-party repo works. When the market seized up in 2008, this created panic among banks, investors and the companies that rely on it for funds. And right now there are at least three reasons why we should pay attention to JPMorgan’s move.

First, and most obviously, it underscores the pressure on all investment banks — including even the supposedly successful ones — to rethink their business models as financial reforms bite and interest rates sink ever lower. A decade ago it would have been hard to imagine a world where JPMorgan abandoned tri-party repo — just as it was hard to picture Goldman Sachs creating a retail bank. Now all manner of taboos are tumbling on Wall Street.

Second, the move also raises questions about the structure of tri-party repo itself. Since JPMorgan announced its withdrawal, US regulators have been trying to reassure financiers and company treasurers that Bony will be able to manage the transition in a calm, orderly way and that it is aware of its systemic responsibilities.

Perhaps so. Bony appears to be a strong bank. But it looks odd to have such an important corner of finance organised as a monopoly in the hands of a private-sector bank. After all, Wall Street is supposed to promote free-market competition and regulators are supposed to dislike concentrations of risk.

So, if nothing else, this shift calls for a wider debate. In the wake of the 2008 financial crisis, the New York Federal Reserve introduced reforms to make the market function more effectively. It should go further and ask whether it is time to use a big industry-owned utility to settle and clear trades instead, such as the Depository Trust & Clearing Corporation; alternatively, it could encourage new entrants or look at other solutions.

But the third crucial point that JPMorgan’s move highlights is the degree to which some of the hidden pipes of finance may be furring up as the banks reshape their business models. The US repo market (of which the tri-party piece is one part) is $2.2tn, according to a review by the Securities Industry and Financial Markets Association, with a similarly large market in Europe. That sounds impressively big. However, daily turnover is about half the level of a decade ago partly because there is less demand for credit, but also because of a reduction in the numbers of brokers and others who organise deals or provide inventories of collateral.

That might not matter immediately; the market is functioning fairly smoothly. But the Bank of England has just published a sobering piece of research suggesting that, if another financial shock hits, it may be hard for the industry to obtain enough high-quality collateral to borrow funds. This, in turn, might cause the wider financing channels in the repo world and elsewhere to freeze in potentially dangerous ways. Models suggest this tipping point is reached if the Vix index — a gauge of investors’ expected volatility — remains at 44 per cent for three months.

Thankfully, there is no sign that this is imminent. The Vix is extremely low, and funding is flowing through the financial channels smoothly, in the tri-party repo world and elsewhere. But it is better to do a safety check on a plumbing system before a crisis hits rather than when there is a nasty blockage.

JPMorgan’s move could be a perfect excuse for regulators and bankers on both sides of the Atlantic to start a wider debate about the repo world. They should use it.

Prosecution of Financial Crisis Fraud Ends With a Whimper


In 2011, Robert Khuzami of the Securities and Exchange Commission announced charges against top executives from Fannie Mae and Freddie Mac. Credit Win Mcnamee/Getty Images                    

One source of great frustration from the financial crisis has been the dearth of cases against individuals over subprime lending practices and the related securitization of bad loans that caused so much financial havoc. To heighten the frustration, I offer Aug. 22, 2016, as the day on which efforts to pursue cases related to subprime mortgages were put to rest with no individuals — save perhaps the unfortunate former Goldman Sachs trader Fabrice Tourre — held accountable.
On that date, the Securities and Exchange Commission settled its last remaining case against a former Fannie Mae chief executive for securities fraud related to the disclosure of the company’s subprime mortgage exposure. The agency accepted a mere token payment that will not even come out of the individual’s own pocket.
On the same day, a federal appeals court refused to reconsider its May ruling that Bank of America’s Countrywide mortgage unit and one of its former executives did not commit fraud by failing to disclose to Fannie Mae and Freddie Mac that the subprime loans it was selling to them did not come close to the contractual requirements for such transactions.
In December 2011, the S.E.C. publicized its civil securities fraud charges against top executives from Fannie Mae and Freddie Mac for understating their exposure to subprime mortgages, which resulted in the government taking them over. Robert Khuzami, then the head of the S.E.C.’s enforcement division, said that “all individuals, regardless of their rank or position, will be held accountable for perpetuating half-truths or misrepresentations about matters materially important to the interest of our country’s investors.”
That is not how it turned out, however. Five of the executives settled in 2015 by arranging for modest payments to be made on their behalf by the companies and their insurers, amounts that were never even described as penalties in the settlements.
Each also agreed not to hold a position in a public company that would require signing a filing on its behalf for up to two years. That is far short of the director and officer bar the S.E.C. usually seeks in such cases, but at least it had the sound of something punitive regardless of whether there was any real impact.
The settlement with the sixth defendant, Daniel H. Mudd, the former chief executive of Fannie Mae, disclosed in a judicial filing on Aug. 22, did not even reach that modest level of accountability.
Fannie will make a $100,000 donation on his behalf to the Treasury Department — which is like shifting money from one pocket to another because the government already controls the company.
Nor is there any ban on Mr. Mudd holding an executive position at another public company, something that at least resulted from the cases against the other executives.

Most S.E.C. settlements involve neither an admission nor denial of the charges, something that has proved frustrating to those who seek accountability, but at least it keeps the defendant from claiming that there was no basis for the case. That is not the situation with Mr. Mudd, however, who told Reuters that the terms would “end a case that should have never been brought.” The S.E.C. usually announces the outcomes of its cases, but the settlement has not yet been posted on the S.E.C.’s website, with the document only available through the court filing system.
What the S.E.C. accomplished in settling the cases against Mr. Mudd and the other executives hardly sends a message to other executives to be careful about how they act in the future. No money came out of the pockets of any of the defendants, and the prohibitions on future activity were token requirements. It was, after all, unlikely that any of the defendants would have been put in a leadership position at a public company within the applicable time. It is difficult not to come away with the impression that the settlements were little more than a slap on the wrist, and perhaps less than that for Mr. Mudd.
The case involving Countrywide may be more disheartening because it calls into question the scope of a federal statute from the savings and loan crisis, the Financial Institutions Reform, Recovery, and Enforcement Act, or Firrea, that the Justice Department used to extract large settlements from banks.
That law authorizes the Justice Department to seek civil penalties for conduct that violates the mail and wire fraud statutes if it affects a bank.
The government won the jury trial in 2013. Preet Bharara, the United States attorney in Manhattan, said that “in a rush to feed at the trough of easy mortgage money on the eve of the financial crisis, Bank of America purchased Countrywide, thinking it had gobbled up a cash cow. That profit, however, was built on fraud.” The trial court hit Bank of America with a $1.267 billion penalty and ordered a former Countrywide executive, the only individual named as a defendant in the case, to pay a separate $1 million fine.
But the United States Court of Appeals for the Second Circuit in Manhattan overturned the verdict last year by ruling that the government had not shown fraud because there was no false statement made when Countrywide sold loans that did not meet certain contractual obligations it had with Fannie and Freddie. The opinion found that “willful but silent noncompliance” with a contract was not fraudulent without some later misstatement.
The government’s aggressive approach to the case may explain why the Justice Department asked the full appeals court to review the decision even though such a request is rarely granted.
The appeals court judges issued a terse order on Aug. 22 denying the government’s request without further comment, which means the only option for challenging the ruling will be to try to take the case to the Supreme Court. The last time the Justice Department asked the Supreme Court to review a case from Mr. Bharara’s office was in United States v. Newman, an insider trading decision. The justices rejected that request before granting review in a similar case from California.
The likelihood that the Supreme Court will take up the appeals court’s decision appears to be low. The issue about what constitutes fraud in a contractual relationship is narrow, raising arcane questions about how a court should construe an agreement between sophisticated parties and when full disclosure is required. This is the type of claim that is usually pursued in a private lawsuit rather than through a federal enforcement action, so the justices may not want to be dragged into a dispute that will have little precedential impact on the application of federal law.
The lack of cases identifying individuals for any misconduct related to the financial crisis has become an all-too common complaint. What will be additionally disheartening to many is that even those few cases that were brought have now ended up largely as defeats for the government.

Banks are preparing for an ‘economic nuclear winter'

The first half of 2016 has been a roller-coaster for financial markets. A combination of uncertainties surrounding the U.K.'s vote to leave the European Union and weaker-than-expected corporate earnings results across the region means a tough second half looms.
European banks, in particular, have had a very tough six months as the shock and volatility around Brexit sent banking stocks south. Major European banks like Deutsche Bank and Credit Suisse saw their shares in free-fall after the referendum's results were announced. In the U.K., RBS was the worst-hit, with its shares plunging by more than 30 percent since June 24.
The current uncertainty over when the U.K. will start the process of quitting the EU has banks on tenterhooks. But a source told CNBC that banks are "preparing for an economic nuclear winter situation."
Speaking on the condition of anonymity due to the sensitive nature of the topic, a source from a major investment bank told CNBC that financial services firms have put together a strategy in place that takes into account the worst-case scenario that could happen by the end of this year.
"This could mean triggering Article 50, referendum in other European nations leading to a break-up of the euro or sterling hitting below $1.20 or lower. The banks are ready for anything now," the source said.
The source further explained that the challenge in 2016 is nothing compared to when the Lehman Brothers collapsed in 2008 and the banking sector is this time a lot more resilient. "Markets hate uncertainty and the events this year have unfortunately created a lot of mystery around what is going to happen next."
Meanwhile, a common theme across second-quarter results has been a warning of uncertain times ahead. From big investment banks to mining firms like BHP Billiton and Glencore to the auto sector, companies have cited uncertainty and volatility in markets as a reason for weak results and have warned that the second half will be challenging.
Following that, a number of banks have cut their exposure to equities due to the volatile nature of stocks in the first half the year. Earlier this month, Goldman Sachs downgraded stocks to "underweight" as part of its 3-month asset allocation citing global equities to be at the upper end of their "fat and flat range."
"The second half of the year is going to be very challenging for U.K. corporates," Craig Erlam, senior market analyst at OANDA told CNBC via email. "Not only are they contending with possible recession in the U.K. and more prolonged slowdown, the uncertainty factor surrounding Brexit leaves planning for the future a very difficult task."
Erlam further explained that a number of companies won't know for a while what the future of their operations in the U.K. will look like.
"I imagine many are already putting plans in place for moving operations abroad should the U.K. lose access to the single market. With companies less likely to invest and recession very possible, the second half of the year isn't looking great, particularly for those companies with greater exposure to the UK."
But while challenges continue to loom, some analysts have said it was important for companies to get on with their business.
"I think the main problem for the second half of the year is the uncertainty caused by Brexit, though that's likely to persist for two years or more, so I suspect companies are likely to roll up their sleeves and get on with their business," Laith Khalaf, senior analyst at Hargreaves Lansdown told CNBC via email.
Khaif explained that the challenges will remain but it is important for industries like banking for instance to focus on maintaining their solvency ratios and "de-risking and simplifying their businesses."

Up and Down Wall Street

The Black Swan Election

The unprecedented 2016 elections could yet throw markets for a loop. A Trump victory or upheaval in Congress could tank the Dow.  

By Randall W. Forsyth

Photos: Bloomberg

“Regrets, I’ve had a few, but then again, too few to mention,” Donald Trump said in so many words last week. After the latest reshuffle at the top of his campaign, My Way probably will remain the Republican presidential nominee’s theme song.
Even with the departure of his former campaign chairman, Paul Manafort (to the tune of “Crimea River” for his connection to pro-Russian forces in Ukraine), the real political news of the week wasn’t the seemingly endless chaos in the Trump campaign that dominated the airwaves.
Rather, writes our buddy Greg Valliere, the chief strategist at Horizon Investments, the big development is that Hillary Clinton looks as if she’s in trouble. “Her campaign looks theme-less and stale—and the Clinton Foundation is a growing liability,” he advises.
The respected poll (if that’s not an oxymoron these days) from Pew Research on Thursday had Hillary holding only a slim lead over Donald, 41% to 37%, which Greg says should be a “wake-up call.” He advised his clients at week’s end that “Clinton isn’t a lock—this race is tightening.”  

We relay this, first, because this election has been like no other, and second, because of the investment implications. As our cover story last week suggested, the stock market’s march to new highs has been helped by the perception that Clinton, the candidate of continuity, or at least less uncertainty, would prevail.
Indeed, Greg says the tightening may not show up in the national polls for a couple of weeks. That’s significant, according to a research note from Alec Phillips of Goldman Sachs, because historically presidential polls’ predictive power rises sharply from here on in. Going back to 1944, polls’ forecasting ability beginning in late August is twice that of 100 days before the November election (late July and early August).
To be sure, poll results are to be taken with a shaker full of salt, especially after pollsters totally blew the call on the Brexit vote in the United Kingdom a couple of months ago. Perhaps that’s because polls “have consistently failed to capture the voting intentions of marginalized and antiestablishment voters,” write Tina Fordham and Tiia Lehto of Citigroup, and the betting markets haven’t been much better, as Brexit also showed.
Yet, they continue, relying on old-school models and mind-sets recalls Einstein’s putative definition of insanity: doing the same thing over and over again but expecting a different outcome. Looking to economic indicators such as gross domestic product and unemployment, or the incumbent’s approval ratings, has less validity in this unconventional year. Moreover, fiscal and monetary matters have declined in importance for voters, which in turn has meant less attention to these issues from the candidates—“a factor that could dismay investors,” they add.
That implies far less certainty about November’s outcome than the pundits and, more importantly, the markets have assumed. To be sure, the Citi team puts a 65% probability on a Clinton victory. But, it also observes, 35% probability events happen all the time.
If that isn’t enough, the presence of candidates beyond the two main parties could further roil the campaign. In a three-way race, one recent poll shows the Libertarian candidate, former New Mexico Gov. Gary Johnson, getting 8.4% compared with 43.1% for Clinton and 37.1% for Trump.
FiveThirtyEight, the data crunchers, add that the Pew Research poll showing Clinton leading Trump 41% to 37% also found Johnson with 10% and Green Party candidate Jill Stein with 4%. Even more interesting is the willingness of younger voters to embrace third-party candidates. Among 18-to-29-year-olds in the aforementioned Pew poll, Clinton led Trump 38% to 27%, with Johnson at 19% and Stein at 9%. Averaging five different polls, Clinton got 41%; Trump, 20%; Johnson, 17%; and Stein, 10%. Thus, the alternative candidates both scored in double digits, with Johnson close to Trump.
The significance, according to Citi, is that if the Libertarian Johnson can garner the 15% needed to be included in the televised debates, it could “introduce further uncertainty in the race in its final weeks.” The debates kick off on Sept. 26, which bumps up against Monday Night Football, to Trump’s professed chagrin.
Odds that the Democrats can win back the Senate also are increasing, according to Goldman. Republicans are trailing in five races and are ahead only slightly in a sixth, while just one Democratic seat looks vulnerable. The GOP now has 54 Senate seats to 46 for Democrats, so the Dems need to win just four to gain a majority if Clinton wins, and five if Trump emerges victorious. (The vice president is the president of the Senate and casts the deciding vote in a tie.)
“This implies the most likely election outcome still appears to be divided government,” Goldman’s Phillips concludes. That would mean lower odds of a more-expansionary fiscal policy than under single-party control. (The odds favor the GOP retaining the House.)
THAT ONCE AGAIN LEAVES the Federal Reserve as the market’s primary focus, at least as far as its myopia lets it peer ahead. Yet even here, politics may enter into deliberations once thought to be confined to technocrats’ parsing data points on the head of a pin.
Last week had the Federal Open Mouth Committee in full session, with an array of central-bank officials voicing their views. That was in addition to the release of minutes of the July 26-27 meeting of the Federal Open Market Committee, the actual policy-setting panel of the Fed. What emerged is a continued split among FOMC members, from those calling for an increase in the Fed’s key policy interest-rate target from the 0.25%-to-0.5% range that was set last December, to those who want to continue to hold off on hikes.
Markets will be anxiously awaiting clarification from Fed Chair Janet Yellen when she delivers a highly anticipated address on Friday morning to the annual Kansas City Fed confab in Jackson Hole, Wyo. While there are 17 Fed governors and presidents, all with access to microphones, Yellen’s voice is more equal than the others.
She is slated to talk on the “Federal Reserve’s Monetary Policy Tool Kit,” but attention will certainly be focused on what she has to say about the shorter term, specifically what might (or might not) happen at the next FOMC meeting on Sept. 20-21.
“The hurdle is too high for a rate hike before the election,” according to rate strategists at Société Générale. Yet they note that New York Fed President William Dudley said in an interview last week that “the market is complacent about the need to gradually hike rates.” Dudley, former chief U.S. economist at Goldman Sachs, knows perhaps better than any other Fed official how market participants will infer such statements.
Still, the federal-funds futures market puts the odds of a quarter-point rate increase by December at a hair above even money, with the betting moving decidedly in favor of an increase only by next March (a 60% chance, by Bloomberg calculations). And the futures market is pricing in only a single hike all through 2017.
But those slim odds may even be too high. “A topic that likely will not be discussed explicitly, but that will influence all policy discussions at Jackson Hole, is the uncertainty raised by the U.S. presidential election and its associated drag on growth,” according to William Lee, Citi’s head of North American economics.
The bank estimates the drag may be slowing gross-domestic-product growth by an annual rate of 1.25%.
As that uncertainty lifts, the consensus view is that the Fed can go ahead with its long-promised rate increase in December. Recall that at the start of the year, central-bank officials were signaling four quarter-point increases. The current guess is for two hikes. It’s unlikely they’d be willing to go oh-for-2016. That also assumes that GDP growth gets back on track. The Atlanta Fed GDPNow forecast for the current quarter is 3.6%, while the New York Fed Nowcast estimates 3%.
“If Trump wins, our conjecture that a trade contraction would induce a recession sooner rather than later implies we have seen the cyclical high point for U.S. rates,” Citi’s Lee avers. In other words, no further rate hikes.
Much of the Jackson Hole discussion will be on new models for monetary policy, which has been pushed far beyond the bounds of previous practices, and yet has fallen short of producing robust growth (that is, other than in asset prices). As noted in this space last week, the result has been an increased interest in fiscal measures, notably infrastructure spending.
On that score, Bank of America Merrill Lynch economists Lisa C. Berlin and Ethan S. Harris write that federal, state, and local infrastructure spending in 2015 fell to its lowest share of economy in the postwar era, just 3.4% of GDP, with 60% at the state and local level and 40%, federal. Most of the money just went to replace depreciated assets; netting out depreciation, the spending was a mere 0.5% of GDP.
Not spending now merely postpones the inevitable, they note. In New York, it’s apparent how neglect and lack of maintenance only makes the ultimate cost higher. “It also makes more sense to borrow and invest now at near-zero interest rates when financing is relatively cheap, than to wait until rates are back to normal,” they conclude.
That would be in a rational world. Even in this crazy campaign, this still ought to be a major point of discussion. 

Decline of Empire: Parallels Between the U.S. and Rome, Part V

by Doug Casey

Despite all our similarities with Rome, and even equipped with our understanding of why Rome collapsed, we can’t avoid Rome’s fate just by trying to avoid Rome’s mistakes. Yes, we have an analogue of early Christianity chewing away at our civilization’s foundations. And yes, we have a virtual barbarian invasion to contend with. But there’s another factor, I think, that worked against the Romans and is working against us… one Gibbon didn’t consider.

We can’t evade the second law of thermodynamics, which holds that entropy conquers everything and that over time all systems degrade and wind down. And that the more complex a system becomes, the more energy it takes to maintain it. The larger and more complex, interconnected, and interdependent it becomes, the more prone it is to breakdown and catastrophic failure. That includes countries and civilizations.

The Romans reached their physical limits within the confines of their scientific, engineering, economic, and other areas of knowledge. And the moral values of their civilization, their founding philosophies, were washed away by a new religion. We may reach our technological limits. And our founding values are certainly being washed away.

Our scientific knowledge is still compounding rapidly—because more scientists and engineers are alive today than have lived in the previous history of mankind put together. That statement has been true for at least the last 200 years—and it’s been a gigantic advantage we’ve had over the Romans.

But it may stop being true in the next few generations as the population levels off and then declines, as is happening in Japan, Europe, China, and most of the developed world. It’s compounded by the fact that U.S. universities aren’t graduating Ph.D.s in engineering, mathematics, and physics so much as in gender studies, sociology, English, and J.D.s in law. As it degrades, the U.S. will not only draw in fewer enterprising foreigners, it will export its more competent natives.

My solution to America’s decline and fall? The solution for declining civilizations is less command and control, less centralization, and less legal and regulatory complexity. And more entrepreneurship, free minds, and radically free markets. Unfortunately, although a few might agree with that, it’s not going to happen. Not even if most people agree.

Why? Because there are immense governmental institutions that exist, with many millions of employees—at least 20 million in the U.S. And many tens of millions more in their families and throughout the private sector that depend on them. And many tens of millions more that rely directly on the state for Social Security, Medicare, Medicaid, and other direct payments. And millions more associated with quasi-state institutions like NGOs, think tanks, law firms, lobbying groups, and the like. The parasitic mechanism of the state has become key to their survival. Even if many in their ranks see the dysfunction now planted in America, they’re hardly going to break their own well-filled rice bowls.

Every institution, like every living thing from an amoeba on up, has one thing in common: they all obey a prime directive—survive! They will try to do so at any cost to society at large. They intuitively know that, as a corollary, you either grow or you die. So you’re not going to see any dysfunctional organization dissolve itself. It’ll keep trying to grow until it self-destructs or an outside force destroys it. Beyond a certain stage, any serious reform is impossible. In the case of the U.S., it’s now host to a completely inoperable cancer, as the government and its satellites grow faster than ever, while the productive economy contracts.

The second law of thermodynamics is a concept of physics, but it has applications in most areas of human action, including what’s been called “imperial overstretch”—the point where the resources gained from growing is less than the energy expended in the process. Rome ran up against imperial overstretch. So did Alexander, Napoleon, and Hitler. The Spanish, French, British, and Soviet empires all did as well. It’s a natural thing with all living organisms, to try to grow until they can’t grow any further, until their energy expenditures exceed their inputs, and/or they’re too large and complex to be controllable, at which point they either rot from within or fall to external predators. It’s as though the Peter Principle applies to all of nature: everything rises to its level of incompetence, at which point it becomes vulnerable.

But does it really matter if the U.S. declines? It’s already morphed from America—which we all loved—into something else. And it’s morphing even more in the wrong direction, at an accelerating rate, as did Rome. The U.S. is declining in all the areas I’ve touched on. But it’s not unique; it’s following the course of all states and all things.

Rome was arrogant and thought it was unique, the center of the world, and eternal. Just like the U.S. Or China, for that matter.

Rome was corrupt; it departed from the values that made it great and so deserved to collapse. The U.S. is increasingly corrupt. That’s completely predictable, for exactly the reason Tacitus cited—a profusion of laws. In market-based systems, corruption is rare and occasional. But in large, complex, politically based systems, it’s not only commonplace, it’s salubrious, because it allows workarounds.

Corruption becomes like an oxygen tank to an emphysema victim—awkward but needed. Rulers, however, never attempt to cure the underlying disease by simplifying the complex systems they’ve built. Instead they pass more laws, making the system ever more like a Rube Goldberg machine, with even more complexities and inefficiencies. That’s always counterproductive, since compounded complexity makes the eventual collapse even worse. And harder to recover from. And more nearly inevitable.


So what’s your takeaway from all this, assuming you agree with my thinking? There are several possibilities to consider, based on what we know about Rome.

One is that you stay put as civilization declines around you and barbarians—of whatever kind—take over. That may be your only, or best, option—perhaps because of your age or financial circumstances or family obligations. If so, it nonetheless may be a mistake to stay in Detroit or Chicago, because there could be easy and much better alternatives. We have evidence that life in parts of the Roman Empire—parts of rural Portugal and Mauretania, for instance—actually improved even as things were collapsing in Italy, Britain, and Gaul, largely because the taxation and regulation infrastructures collapsed, but the roads, aqueducts, and cities stayed intact. So you might improve your own situation considerably just by moving down the road a bit.

A second possibility is that you consider what Priscus and Salvian said and get away from the storm’s epicenter by leaving the empire. Welcome to Cafayate, where I plan on spending an increasing amount of my time.

A third is more philosophical: you simply recognize that the rise and fall of societies has been going on since Day One. Don’t be too stressed by mega events. Life isn’t just full of problems: it is problems. We’re looking at a giant crisis, but a crisis is a combination of both danger and opportunity. Look at the bright side while you try to dodge the negative effects. See it as an adventure, an education, and even free entertainment.

I hope seeing America reflected in the distant mirror of Ancient Rome helps to put things in perspective.