As other nations’ surpluses turn to deficits, America will face competition in global financial markets for its borrowing needs

TO BE NOTED: From the NY Times:

"Worries Rise on the Size of the U.S. Debt

By GRAHAM BOWLEY and JACK HEALY

The nation’s debt clock is ticking faster than ever — and Wall Street is getting worried.

As the Obama administration racks up an unprecedented spending bill for bank bailouts, Detroit rescues, health care overhauls and stimulus plans, the bond market is starting to push up the cost of trillions of dollars in borrowing for the government.

Last week, the yield on 10-year Treasury notes rose to its highest level since November, briefly touching 3.17 percent, a sign that investors are demanding larger returns on the masses of United States debt being issued to finance an economic recovery.

While that is still low by historical standards — it averaged about 5.7 percent in the late 1990s, as deficits turned to surpluses under President Bill Clinton — investors are starting to wonder whether the United States is headed for a new era of rising market interest rates as the government borrows, borrows and borrows some more.

Already, in the first six months of this fiscal year, the federal deficit is running at $956.8 billion, or nearly one seventh of gross domestic product — levels not seen since World War II, according to Wrightson ICAP, a research firm.

Debt held by the public is projected by the Congressional Budget Office to rise from 41 percent of gross domestic product in 2008 to 51 percent in 2009 and to a peak of around 54 percent in 2011 before declining again in the following years. For all of 2009, the administration probably needs to borrow about $2 trillion.

The rising tab has prompted warnings from the Treasury that the Congressionally mandated debt ceiling of $12.1 trillion will most likely be breached in the second half of this year.

Last week, the Treasury Borrowing Advisory Committee, a group of industry officials that advises the Treasury on its financing needs, warned about the consequences of higher deficits at a time when tax revenues were “collapsing” by 14 percent in the first half of the fiscal year.

“Given the outlook for the economy, the cost of restoring a smoothly functioning financial system and the pending entitlement obligations to retiring baby boomers,” a report from the committee said, “the fiscal outlook is one of rapidly increasing debt in the years ahead.”

While the real long-term interest rate will not rise immediately, the committee concluded, “such a fiscal path could force real rates notably higher at some point in the future.”

In some ways, ballooning deficits should not matter. Deficits are a useful way for governments to use public spending to stimulate the economy when private demand is weak. This works as long as a country closes its deficit and pays back its borrowings after its economy starts to recover.

The trouble is that government borrowing risks crowding out private investment, driving up interest rates and potentially slowing a recovery still trying to take hold. That is why the Federal Reserve announced an extraordinary policy this year to buy back existing long-term debt — $300 billion over six months — to drive down yields. The strategy worked for a while, but now the impact of that decision appears to be wearing off as long-term interest rates tick up again.

Then there is the concern that the interest the government must pay on its debt obligations may become unsustainable or weigh on future generations. The Congressional Budget Office expects interest payments to more than quadruple in the next decade as Washington borrows and spends, to $806 billion by 2019 from $172 billion next year.

“You’re just paying more and more interest and having to borrow more and more money to pay the interest,” said Charles S. Konigsberg, chief budget counsel for the Concord Coalition, which advocates lower deficits. “It diverts a tremendous amount of resources, of taxpayer dollars.”

Of course, no one is suggesting the United States will have problems paying the interest on its debt. On Wednesday, even as it announced its huge financing needs for the latest quarter, the Treasury said financial markets could accommodate the flood of new bonds. “We feel confident that we can address these large borrowing needs,” said Karthik Ramanathan, the Treasury’s acting assistant secretary for financial markets.

One worry, however, is that there are fewer eager lenders to buy all that American debt. Most of the world is in recession, and other nations have rising borrowing needs as well. As other nations’ surpluses turn to deficits, America will face competition in global financial markets for its borrowing needs. For the moment, the United States is actually benefiting from a flight to quality into Treasuries brought on by the global financial crisis, which helped reduce rates to record lows this winter. But the influx will not continue forever.

China has lent immense sums to the United States — about two-thirds of its central bank’s $1.95 trillion in foreign reserves is believed to be in United States securities — but it has begun to voice concerns about America’s financial health.

To calm nerves and fill the deficit hole, the government is getting creative. The Treasury is ramping up its auction calendar, holding more frequent sales of government debt and selling the debt in expanded amounts. It is now holding sales of its 30-year bond each month, up from four times annually.

It is also resuscitating previously discontinued bonds, such as the seven-year note and the three-year note, to try to mop up any available money all along the yield curve. There is even talk of issuing billions of dollars of a new 50-year bond, though the idea has not won official approval.

On a second front, the Treasury and the Federal Reserve are trying to bolster the mechanics of the market — to make sure every auction goes smoothly. With such enormous sums involved, every extra basis point on the interest rate the government pays could mean extra billions of dollars for the taxpayer. Earlier this year, when demand was hesitant at a Treasury auction and when a British bond auction went poorly, investors grew nervous that the government might struggle to sell its mountain of debt.

To avoid such an outcome and to keep borrowing costs low, the government is trying to expand the group of firms that bid at Treasury auctions. After the demise of such names as Lehman Brothers, the number of these firms, called primary dealers, has shrunk to 16, the smallest since this elite club was formed decades ago. Now the government is in discussions with smaller firms like Nomura and MF Global to persuade them to join."

This flight to quality and demand for liquidity causes investors to flock to the safest investments.

TO BE NOTED: From Disciplined Approach to Investing:

"Diversification and Correlation During Market Crisis Periods

One factor that has been painfully clear in this market downturn is the high correlation of nearly all asset classes. The result for investors is nearly all the asset classes experienced significant declines during the recent market contraction. So what is the purpose of diversification if it does not minimize the negative portfolio returns during stress market periods? The answer begins with the question as to what are investors trying to diversify.

During periods of market stress there tends to be two factors that influence the price of investments:

• there is a flight to quality and
  
• a high demand for liquidity

This flight to quality and demand for liquidity causes investors to flock to the safest investments. For fixed income this tends to be government bonds and for equities it tends to be high quality equities. These high qulaity equities tend to be large cap blue chip dividend growth stocks.

A recent paper by Barclays Global Investors titled, Is Diversification Dead?, provides more detail on the conundrum for investors as it relates to the diversification issue.

Is Diversification Dead

Publish at Scribd or explore others: Business & Economics Research correlation diversification

In the end though, it is difficult to predict when the market will experience these significant drawdowns. For investors, building the foundation of the equity portion of their investment portfolio in high quality dividend paying stocks is one way to potentially gain some assurance they will not experience significant market value erosion in market downdrafts.

As I have written several times before, when the market rallies off of a bottom during these corrective phases, the higher quality equity investments will likely lag the broader market returns though.

Sphere: Related Content

More on this topic (What's this?)

Diversification Across All Asset Classes (Investing School, 3/23/09)

What is Diversification (Forex Analysis, 4/15/09)

Investors and diversification (Canadian Business Blog, 2/13/09)

Read more on Diversification at Wikinvest

Posted by David Templeton, CFA at 9:52 PM

create liquidity spirals in which shocks to market liquidity reduce funding liquidity which in turn further reduces market liquidity

TO BE NOTED: From All About Alpha:

"A new look at who is more susceptible to “hedge fund contagion” Apr 2nd, 2009 | Filed under: Today's Post

In August 2007, as quant hedge funds were swooning in an eerie precursor to the credit crunch, we reported on an academic study of “hedge fund contagion” (see post). Researchers found “no systematic evidence of contagion from equity, fixed income, and currency markets to hedge fund indices”. However, they did find that there was a contagion between hedge fund strategies themselves.

Now a new paper on this topic explores whether the correlation between hedge fund returns changes depending on market conditions and the overall performance of hedge funds. Possible “asymmetric correlation” between hedge funds is of critical importance to funds of funds, and by extension, anyone hoping to benefit from hedge funds’ reputed lack of correlation with each other and with equity indices.

Evan Dudley and Mahendrarajah Nimalendran of the University of Florida focus their attention on the correlation between extreme hedge fund returns only - i.e., those that occur in the left and right tails of the return distribution. Their hypothesis is that the correlation between hedge fund returns is somehow different during these extreme events than they are during “normal” times (a reasonable hypothesis given the often-cited hyperbole about how “all correlations go to one” in times of distress).

It turns out their hunch was correct. However, the extent to which correlations increased in hard times was different across various hedge fund strategies. Dudley and Nimalendran first examined the correlation between several hedge fund strategies and the S&P 500. They divided the return distribution of each strategy into quantiles and compared each quantile to the S&P 500. The chart below from the paper shows how two particular hedge fund strategies, Long/Short Equity and Event Driven stacked up:

The correlation between Long/Short Equity returns and S&P 500 returns was much higher in the left side of the L/S/ return distribution than it was in the right side of the L/S return distribution. The same was true for Event-Driven funds. In both cases, the correlation was much lower in the right “tail” of the return distributions and higher in the left tail (the bad tail).

However, this wasn’t the case for all hedge fund strategies. Global Macro and Market Neutral, two strategies that have recently shown a low market correlation, had relatively consistent correlations with the S&P 500 in both good times and bad.

Interestingly, Market Neutral funds seemed to have a negative S&P 500 correlation at the far end of both tails.

The results were somewhat similar, but less extreme, when each hedge fund strategy was compared not to the S&P 500, but to the broad universe of hedge funds. So if you’re tasked with monitoring a portfolio of individual hedge funds, and you’re being asked tough questions about the reputed diversification properties of hedge funds, you might want to check out this paper."

Hedge Fund Contagion, Liquidity Spirals, and Flight to Quality

Mahendrarajah Nimalendran
affiliation not provided to SSRN

Evan Dudley
University of Florida - Warrington College of Business


March 18, 2009


Abstract:
We develop a novel approach that investigates the economic determinants of contagion among hedge funds. Our approach explicitly takes into account the left tail dependency between returns. We empirically investigate the relative importance of three economic channels that potentially explain contagion among hedge fund indices. We find that funding liquidity (proxied by margins on equity and currency futures contracts for members of the Chicago Mercantile Exchange), which captures the extent to which a fund can finance its positions, is a significant determinant of financial contagion. Our results on funding liquidity confirm the predictions made by Brunnermeier and Pedersen (2009) that market liquidity and funding liquidity interact to create liquidity spirals in which shocks to market liquidity reduce funding liquidity which in turn further reduces market liquidity. Our results also show that "flights to collateral" of the nature described in Fostel and Geanakoplos (2008) are a significant determinant of contagion among some types of hedge fund strategies. We find little support for the third channel, which is the consumption effect described Fostel and Geanakoplos (2008), whereby asset prices decrease because bad news about one asset class increases the price of risk for all securities.

Keywords: Hedge fund, contagion, asymmetric correlation, copula, flight to quality, liquidity

JEL Classifications: G31, G32

Working Paper Series

“There are some really extraordinary opportunities in the credit world,”

Were I an investor, I would actually do this:

"By Oliver Staley

Jan. 2 (Bloomberg) -- Yale University, whose endowment dropped $5.9 billion in six months because of the recession, is pursuing a recovery by acquiring distressed debt.

“There are some really extraordinary opportunities in the credit world( I AGREE ),” said David Swensen, the school’s investment chief, in a phone interview from his office at the New Haven, Connecticut, university. “Everything, from bank loans to investment-grade bonds to less-than-investment grade bonds, is priced at really extraordinarily cheap levels( I AGREE ).”

Swensen, 54, increased Yale’s endowment to $22.9 billion on June 30, from $1 billion in 1985 when he assumed the job, making it the second-wealthiest university in the U.S. The school estimated on Dec. 16 that the fund had fallen 25 percent, to $17 billion, because of the global financial crisis. Swensen, who has updated his 2000 book on investing for re-release Jan. 6, said periodic losses are inevitable in a portfolio tilted toward stocks and built to grow over many years.

“There isn’t an investment strategy that can produce the kind of long-term results we’ve generated at Yale that isn’t going to post the occasional negative return,” Swensen said in the Dec. 30 interview. “I don’t think people should disregard the book because of the market trauma of the last few months. We’re not even done with the current fiscal year. Judging a long-term investment strategy based on the results of a five- to six-month period is foolish beyond words( I AGREE ).”

‘Flight To Quality’( OR FLIGHT TO SAFETY )

Among Swensen’s core principles identified in “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment” (Free Press, 408 pages, $35) is the importance of diversifying holdings while focusing on equities. In a recession, the advantages of diversification get overwhelmed( I AGREE ) by investors’ selling equities in favor of U.S. Treasury bonds in a “flight to quality,” he said.

“When you have a market in which any type of equity exposure is being punished, it’s going to hurt long-term investors,” he said.( TRUE )

In the current environment, distressed corporate securities can produce “equity-like” returns, Swensen said.

“You want to make sure you’re with companies that have the ability to survive in a really tough economic environment” he said, declining to name any of the companies.( I WONDER WHY? )

Yale, one of eight schools in the elite Ivy League in the northeastern U.S., dates from 1701. The school, which has about 13,100 students, trails only Harvard University in wealth. Harvard, in Cambridge, Massachusetts, had an endowment valued at $36.9 billion on June 30 before reporting losses of about $8 billion, or 22 percent.

Ph.D. in Economics

Swensen earned a Ph.D. in economics at Yale before working for Lehman Brothers Holdings Inc. and Salomon Brothers, now a unit of Citigroup Inc. When he took over Yale’s endowment, the fund contributed $45 million, or 10 percent, to the school’s annual budget. In the current fiscal year, which will end on June 30, the endowment is expected to contribute $1.15 billion, or 45 percent of Yale’s revenues, he said in the book.

The distribution from the endowment is based on an average of five years of returns, so the consequences of any loss this fiscal year will be blunted by the gains of previous years, Swensen said.

“We’re projecting no decline in endowment support for the operating budget,” he said.

Since the budget is due to grow in coming years, Yale President Richard Levin has said the school is projecting an operating shortfall of $100 million for fiscal 2010, increasing to more than $300 million four years later. The school estimates no growth in the endowment in fiscal 2010, with increases resuming in 2011.

Slashing Spending

To begin closing the budget gap, the school will slow increases in salaries, and cut budgets for non-faculty staff pay by 5 percent through attrition. Yale said it will reduce other expenses 10 percent over two years by slashing spending on consultants, travel and energy while delaying construction.

Until financial institutions resume lending( FEAR AND AVERSION TO RISK ), the economy will remain stagnant, Swensen said.

“I don’t think the Fed or the administration has figured out how to fix credit markets( BAGEHOT'S PRINCIPLES ),” he said. “We are going to experience economic and financial stress as long as the credit markets are broken and it’s not until we start seeing the credit markets functioning properly will we be able to see a path to economic recovery.”

Swensen advocates federal guarantees for deposits in money- market funds as a way to encourage investment in the vehicles that buy corporate debt( A GOOD IDEA. AS I'VE SAID, YOU'RE GOING TO NEED EXPLICIT GOVERNMENT GUARANTEES TO STOP A CALLING RUN. ).

Swensen’s book is updated to stress the importance of organization and governance for investment firms.

Bernard Madoff

Concerns over governance helped Yale stayed clear of Bernard Madoff, the financier accused of a $50 billion fraud. One reason was an inability to see where investors’ money was going, Swensen said.

“If we can’t sit down with the people making the decisions, and understand what it is they’re doing and how they’re doing it, we’re not going to invest,” he said. “We’re not going to have anything to do with it.”

If Madoff’s victims had read his book, Swensen said, Madoff, who relied on money from so-called funds of funds to feed his operation, “never would have been funded.”

“The reason I don’t like funds of funds is that they facilitate the flow of ignorant capital( SEEMS APT ),” Swensen said.

In general, most investors should stick to passive investments such as index funds that track the market, since attempts to outperform it are often unsuccessful( I AGREE ). For every winner there is a loser, and even the winners pay for much of their gains in fees and commissions, he writes in his book.

Contrarian Investing

“Casual attempts to beat the market provide fodder for organizations willing to devote the resources necessary to win,” he wrote.

Building Yale’s endowment required sticking to a contrarian investing philosophy, a high-performing research team, and the ability to coax “uninstitutional behavior( HUMAN AGENCY EXPLANATION ) from institutions,” Swensen said.

“Nobody said this was easy,” he said. “You’ve go to do an enormous amount of work to get it right.”

To contact the reporter on this story: Oliver Staley in New York at ostaley@bloomberg.net."

He makes some very good points.

"Their mission is to provide liquidity to the system by acting as lender-of-last-resort "

Casey Mulligan:

"Flight to Quality( FLIGHT TO SAFETY ) -- Cause or Effect?

Professor Lucas is a strong advocate.

I agree that there is a flight to quality( I AGREE ). Professor Lucas says that one way that people attempt to buy safe securities is to spend less on consumption goods. That makes sense -- but the same logic implies that people should work harder (earn more) as another means to accumulate those securities. The facts show that people are working less.( WHY ? COULDN'T IT HAVE TO DO WITH EMPLOYERS CUTTING BACK? ) Barro and King (1984) explained it best -- the basic puzzle of recessions (this one included) is that consumption and leisure move in opposite directions. Wealth effect and intertemporal substitution effect explanations of recessions (Professor Lucas' story is one example) imply that they move together.

That's why I believe that the "flight to quality" is a symptom( HERE I AGREE ) rather than a cause.

Professor Lucas arrives at the conclusion that the Fed should print money. Despite the arguments above, I agree that such a Fed policy would do more help than harm( I AGREE )."

Now Lucas in the WSJ:

"The Federal Reserve's lowering of interest rates last Tuesday was welcome ( TRUE ), but it was also received with skepticism( THAT'S FINE ). Once the federal-funds rate is reduced to zero, or near zero, doesn't this mean that monetary policy has gone as far as it can go? This widely held view was appealed to in the 1930s to rationalize the Fed's passive role as the U.S. economy slid into deep depression.

It was used again by the Bank of Japan to rationalize its unwillingness to counteract the deflation and recession of the 1990s. In both cases, constructive monetary policies were in fact available but remained unused( TRUE ). Fed Chairman Ben Bernanke's statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending( TRUE ).

There should be no mystery about what he has in mind. Over the past four months the Fed has put more than $600 billion of new reserves into the private sector, using them to discount -- lend against -- a wide variety of securities held by a variety of financial institutions. (The addition is to be weighed against September 2007's total outstanding level of reserves of about $50 billion.)

This action has been the boldest exercise of the Fed's lender-of-last-resort function( I AGREE THAT THIS IS WHAT IT IS ) in the history of the Federal Reserve System. Mr. Bernanke said that he is prepared to continue or expand this discounting activity as long as the situation dictates( I AGREE WITH HIM ).

Why do I describe this as an action to stimulate spending? Financial markets are in the grip of a "flight to quality"( FLIGHT TO SAFETY ) that is very much analogous to the "flight to currency"( I AGREE. IT'S LIKE A BANK RUN. HOWEVER, I SEE IT AS A FLIGHT TO EXPLICIT GUARANTEES FROM IMPLICIT GUARANTEES ) that crippled the economy in the 1930s. Everyone wants to get into government-issued and government-insured assets, for reasons of both liquidity and safety( TRUE. IT'S BOTH. ). Individuals have tried to do this by selling other securities, but without an increase in the supply of "quality" securities these attempts do nothing but drive down the prices of other assets( TRUE ). The only other action people can take as individuals is to build up their stock of cash and government-issued claims to cash by reducing spending. This reduction is a main factor in inducing or worsening the recession( TRUE ). Adding directly to reserves -- the ultimate liquid, safe asset -- adds to supply of "quality" and relieves the perceived need to reduce spending( TRUE. STILL THE FLIGHT TO SAFETY ).

When the Fed wants to stimulate spending in normal times, it uses reserves to buy Treasury bills in the federal-funds market, reducing the funds' rate. But as the rate nears zero, Treasury bills become equivalent to cash, and such open-market operations have no more effect than trading a $20 bill for two $10s. There is no effect on the total supply of "quality" assets.

A dead end? Not at all. The Fed can satisfy the demand for quality by using reserves -- or "printing money" ( GO FOR IT )-- to buy securities other than Treasury bills. This is the way the $600 billion got out into the private sector.

This expansion of Fed lending has not violated the constraint that "the" interest rate cannot be less than zero, nor will it do so in the future. There are thousands of different interest rates out there and the yield differences among them have grown dramatically in recent months. The yield on short-term governments is now about the same as the yield on cash: zero. But the spreads between governments and privately-issued bonds are large at all maturities. The flight to quality means exactly that many are eager to trade private paper for non-interest bearing (or low-interest bearing) reserves and with the Fed's help they are doing so every day( TRUE, ALTHOUGH IT SOUNDS FOOLISH ).

Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are not willing to offer. They are not searching for underpriced "bargains" on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lender-of-last-resort. We don't care about the quality of the assets the Fed acquires in doing this( WE DO CARE ). We care about the quantity of its liabilities( OK ).

There are many ways to stimulate spending, and many of these methods are now under serious consideration. How could it be otherwise? But monetary policy as Mr. Bernanke implements it has been the most helpful counter-recession action taken to date, in my opinion, and it will continue to have many advantages in future months. It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. The cash comes in the form of loans.( I'D PREFER SIMPLY PUTTING MONEY OUT AND LEAVING IT )It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These seem to me important virtues( THAT'S A GOOD POINT )."

More or less, I agree.