Posts filed under “Think Tank”
What if the Fed were a Bank?
By Bob Eisenbeis and David R. Kotok
July 7, 2009
Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com.
David R. Kotok is the Chief Investment Officer of Cumberland Advisors.
Abstract: Our joint commentary identifies two risk measures—capital ratios and duration—which may be helpful in assessing outcomes of the Fed’s exit strategy. We have avoided a fully prepared technical paper and admit that the issues are complex for many of our readers. To assist readers, we have divided this paper into two parts. The first part describes the Fed’s balance sheet in terms that are more commonly understood because they are applied to banks. Of course, we know that the Fed is not a bank. We choose the bank as a reference since it is the basis now for many federal programs. We demonstrate that if the Fed were a bank it would be capital constrained. In the second and more technical part, we use McCauley duration to measure the risk building in the Fed’s new balance sheet construction. We estimate that a 1% upward parallel shift in the yield curve could render the Fed technically insolvent, if it had to mark to market as a bank is required to do.
If the Fed were a bank and had to live up to the same capital requirements as the institutions it regulates, would it be adequately capitalized? This may seem like an absurd question. After all, a central bank can’t go bankrupt. This is especially true for the Federal Reserve, whose balance sheet historically has been quite simple compared to even that of a moderately sized bank.
Until recently, the Fed’s assets consisted primarily of US Treasury debt, typically with relatively short maturities. There was no credit risk and the Fed usually didn’t engage in the buying and selling of those assets. Rather, it bought and held them to maturity. This strategy provided the justification for the Fed not to mark those assets to market as interest rates changed.
Open market operations were usually conducted using repurchase agreements (RP) and reverse repurchase agreements (RRP), where securities were temporarily sold (bought) with an agreement to buy (sell) them back to the holder at an agreed-upon price. These RP transactions were normally done for overnight or for three-day maturities. They served to decrease or (increase) the outstanding supply of Federal Funds, which are the cash reserves banks trade among themselves. Most importantly, they determined the overnight Fed Funds rate, which was the primary instrument of Fed policy. They also linked the Treasury securities market to the Federal Funds market, because Treasury securities were used in the RP transactions.
Until the recent crisis, the Fed’s liability structure consisted mainly of currency held by the public (Federal Reserve notes), deposits held by member banks in the form of excess and required reserves, and deposits of the US Treasury. Currency accounted for about 90% of the Fed’s outstanding liabilities. Individual notes roll over as they wear out, but they are simply replaced with new ones. The total currency outstanding volumes fluctuated slightly with changes in the demand for cash. Cash demanded by the public includes foreign demand and what was needed in automated teller machines (ATMs).
Currency is effectively a permanent source of funding for the Fed, and its maturity is nearly infinite. Until just recently, none of the reserve deposits paid interest. Of course, cash pays no interest. So the currency component of the Fed’s balance sheet has a zero cost of carry.
Today, the Fed holds a wide range of loans and other assets acquired as part of its efforts to combat the financial crisis. The financing of those assets has also changed. As a result, the Fed’s balance sheet is not so simple and is now exposed to a significant amount of both credit and interest-rate risk.
The Fed just released a consolidated balance sheet as of May 27, as part of a new monthly report on “Credit and Liquidity Programs.”1 The report lists consolidated Federal Reserve System assets at $ 2.082 trillion and total capital at $45 billion. This implies a capital-to-assets ratio of 2.16%., which would also be the Fed’s tangible equity capital ratio. Keep in mind that the Fed’s target tangible equity capital ratio for banks is 4%.
Following an almost 50 bps drop in yields over the past month, the $35b 3 year auction was mixed. The yield was almost 3 bps above where the when issued was trading just prior. On the other hand, the bid to cover was good at 2.62 (but below the level of the June auction) and…Read More
> We are stunned – no, we’re shocked, shocked over the following admission from an Assistant US Attorney about the theft of Goldman’s proprietary trading codes. Bloomberg: At a court appearance July 4 in Manhattan, Assistant U.S. Attorney Joseph Facciponti told a federal judge that Aleynikov’s alleged theft poses a risk to U.S. markets. Aleynikov…Read More
Category: Think Tank
Comments today from the British Chambers of Commerce highlight the favorable backdrop, in my opinion, for hard assets/commodities as they call on the Bank of England to print more money. Not only do they want the BoE to complete its current asset purchase plan but “they should go beyond 150b pounds” as while the “worst…Read More
There are those who sweat over every decision, worrying about how it will affect their lives and investments. Then there is the school of thought that we should focus on the big decisions. I am of the latter school.
85% of investment returns are a result of asset class allocations and only 15% come from actually picking investment within the asset class. Getting the big picture right is critical. In this week’s Outside the Box we look at a very well written essay about the biggest of all question in front of us today. Do we face deflation or inflation?
This OTB is by my good friends and business partners in London, Niels Jensen and his team at Absolute Return Partners. I have worked closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work at www.arpllp.com and contact them at firstname.lastname@example.org.
John Mauldin, Editor
Outside the Box
Make Sure You Get This One Right
By Niels C. Jensen
“You can’t beat deflation in a credit-based system.”
As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won’t have to get more than a handful of key decisions correct – everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.
Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those ‘make or break’ decisions which will effectively determine returns over the next many years. The question is a very simple one:
Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?
Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or ‘quantitative easing’ as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?
A Story within the Story
Following the collapse of the biggest credit bubble in history, there has been no shortage of finger pointing and the hedge fund industry, which has always had an uncanny ability to be at the wrong place at the wrong time, has yet again been at the centre of attention. And politicians, keen to divert attention away from themselves as the true culprits of the crisis through years of regulatory neglect, have been quick at picking up the baton. Admittedly, the hedge fund industry is guilty of many stupid things over the years, but blaming it for the credit crisis is beyond pathetic and the suggestion that increased regulation of the hedge fund industry is going to prevent future crises is outrageously naïve.
If you prohibit private investors from investing in hedge funds which on average use 1.5-2 times leverage but permit the same investors to invest in banks which use 25 times leverage and which are for all intents and purposes bankrupt, then you either don’t understand the world of finance or you don’t want to understand. Shame on those who fall for cheap tactics.
Let’s begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that ‘less bad’ doesn’t necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn’t suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.
Going forward, not only will economic growth disappoint, but the economic cycles will become more volatile again (see chart 1) with several boom/bust cycles packed into the next couple of decades. This is a natural consequence of the Anglo-Saxon consumer-driven growth model having been bankrupted. Growing consumer spending over the past 30 years led to rapidly expanding service and financial sectors both of which will now contract for years to come as overcapacity forces players to downsize.
This will again lead to higher corporate earnings volatility which will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. At the bottom of every major bear market in the last 200 years, P/E ratios have been below 10. As you can see from chart 2 overleaf, few countries are there yet. The next decade is therefore not likely to be a ‘buy and hold’ market for equity investors. The combination of low economic growth and pressure on valuations will create severe headwinds. The most likely way to make money in equities will be through more active trading.
Category: Think Tank
Good Evening: After early losses in the wake of Thursday’s very poor unemployment report, the major U.S. stock market averages rallied back this afternoon to finish mixed. Shares of financial companies and traditionally defensive names made for odd bedfellows in leading today’s comeback, but economically sensitive sectors like materials were heavy for most of today’s…Read More
The euro is rallying to the highest level of the day vs the $ after a Canadian official, speaking anonymously, said that while the G8 will likely discuss the US$ and its reserve currency status, there will not be explicit US$ reserve currency comments in the official communique. With about 70% of China’s almost $2…Read More
The Treasury’s 10 yr TIPS auction was solid as the yield was about 1 basis point below expectations and the bid to cover of 2.51 is the highest since Jan ’00 and well above the average over the past year and a half of 2.13. The level of indirect buyers at 49.7% is no longer…Read More
The June ISM services number was one point more than expected at 47 and up from 44 in May and it’s at the highest since Sept ’08 when it was at 50, the cut off between contraction and expansion. Business Activity rose 7.4 points to just shy of 50 at 49.8. New Orders rose to…Read More