double downward spiral involving the financial sector and balance sheets and asset prices on the one hand and the real economy on the other

TO BE NOTED: From The Growth Blog:

"The Financial and Economic Crisis and the Developing World: Where We Are and Where We Are Going

By Michael Spence

Created 04/14/2009 - 16:46

The financial system in the USA and much of Europe had a heart attack in September 2008. As in the case of a real heart attack, the highest priority has gone to the emergency response and to stabilizing the patient. Once that is done and the crisis is abating and even to some extent as it is going on, it will be important (economically and politically) for some to focus on two related issues: What created the rising risk of an attack? And what combination of actions post-crisis will reduce the risk of a repeat in the future.

There are related issues. Are there lessons in the current crisis (and past ones) or is each one sufficiently idiosyncratic so that reregulating with reference to the past does little to limit the potential future damage. Globally, what is the appropriate tradeoff between risk reduction on the one hand and higher costs of capital and lower growth on the other? Is the financial sector different from most others in that when it malfunctions, the rest of the economy malfunctions along with it, and if so should it be treated differently? Will investors learn from this crisis to a point that much of the “re-regulation” will come from adjusted investor behavior and risk assessment procedures? Or are there inherently large divergences between private and social objectives that need to be aligned through regulatory and oversight structures? Are the answers the same for domestic economies and financial systems and for the global aggregate, or are they fundamentally different?

In climate change there are issues of mitigation (prevention or risk reduction) and adaptation. Good policy is a mix of the two. Corner solutions are unlikely to be the right answer. A similar issue arises in the present case. Whether or not regulation and oversight are adequate depends upon the risks and the consequences of financial instability and distress and the latter depends on the existence and effectiveness of response mechanisms. We will need to talk about both in a coordinated way.

The Crisis of September 2008

Credit locked up, interbank lending stopped, and the payments systems' started to malfunction in the US and much of Europe. The TED spread (The interest rate differential between t-bill rates and LIBOR) and related measures of risk at the heart of the financial, payments and credit system rose from its normal 100 basis points to between 4 and 5 hundred basis points. Asset prices declined rapidly, balance sheets in the financial sector further deteriorated and the household sector experienced a massive wealth loss, triggering a reduction in consumption. The double downward spiral involving the financial sector and balance sheets and asset prices on the one hand and the real economy on the other accelerated and has only recently shown evidence of deceleration.

The financial crisis quickly became an economic problem and then a crisis. Asset price declines (equities globally lost $25-30 trillion or more in a four month period) and very tight credit caused investors and consumers to become extremely cautious, causing consumption to fall and the real economy to turn downward. There was no near-term bottom and few brakes to slow the downward momentum.

A complete credit lock-up (and a depression-like scenario in which businesses that rely on credit simply fail) was averted through rapid action by central banks using a growing variety of programs to increase liquidity or directly supply credit, thereby circumventing the normal channels that were damaged and not functioning. The balance sheet of the Fed more than doubled in size from less than a trillion to more than two trillion and with recent commitments is on its way to 3 trillion dollars.

There were two further issues of central importance. First, the markets in a variety of securitized assets stopped functioning. The shadow banking system through which a substantial portion of credit is provided in the US, froze up. Second, because of a combination of leverage and damaged assets, there was and is a potentially large solvency problem in a significant number of large and systemically important institutions. The solvency and related transparency issues continue to be with us today.

The effects on the developing world were immediately felt, though the awareness of the magnitude increased over time. The two important channels were aggregate demand (globally), and the availability and cost of credit and financing. A third channel, rapid shifts in relative prices apart from credit spreads, were important but on balance beneficial.

The financial channel was dramatic. Credit tightened pretty much instantly in the developing world as capital either rushed back to the advanced countries or stopped flowing out, to deal with damaged balance sheets and capital adequacy problems in the advanced countries. The currencies of all major developing countries except for China depreciated against the dollar. Developing countries with reserves used them to stabilize the net capital flows and to partially restore credit and financing. Trade financing dried up and other capital flows diminished or disappeared. The IMF intervened in several cases while financing and bilateral swap arrangements of a variety of kinds were made by the US and China. Credit remains tight and high priced and there is a continuing need for additional financing on a broad front. The IMF did not have the resources in the fall of 2008. Expanding those resources significantly was part of the G20 agenda. At the G20 summit in early April, an important commitment was made to expand IMF resources by over $1 trillion to restore the availability of trade and other forms of finance on an interim basis to developing countries that need it.

The second channel was aggregate demand and trade. As aggregate demand in the advanced countries dropped for the aforementioned reasons, global aggregate demand fell and with it trade: exports and imports. The trade data show a stunning drop in exports, considerably more than in aggregate demand. In many developing countries that rely on external demand and exports as an engine of growth, the immediate negative effect was lower growth, reduced employment and reduced consumption triggering the usual domestic recessionary dynamics.

Globally, the intent is to counter this loss of aggregate demand with coordinated fiscal stimulus programs in the advanced countries and in developing countries to the extent it can be done without jeopardizing fiscal sustainability. The latter capacity varies considerably across countries. There is dissension in the G20 as to what the right order of magnitude is. There are also issues of free riding and protectionism. It is understandable that citizens in various countries facing fiscal deficits and large future debt service obligations prefer to have the benefits of a stimulus program land domestically.

I have described this incentive structure elsewhere as akin to a prisoner’s dilemma with the non-cooperative dominant strategies being either stimulus with some protectionism or free-riding depending on the size and openness of the economy. One can think of that portion of the G20 effort, the part devoted to openness, as attempting to shift policies away from the non-cooperative Nash equilibrium. Evidently, from data on increases in protectionist measures, this will be only partially successful, but partial success is probably much better than no effort at all. Realistically we may not have the option of choosing the first best, coordinated stimulus with openness, but rather have to be satisfied with an effort at coordinated stimulus with some protectionism, as opposed to openness with feeble stimulus commitments.

More generally there is confusion and disagreement about the role of government in the context of a crisis. I have written at somewhat great length about this issue here [1]. This disagreement complicates the politics of timely and effective intervention and has to be factored into the risk assessments for policy makers and private investors and consumers alike. One thing is clear. Government has become a major player in the financial system and the economy. In the financial system it has morphed from regulator to regulator and participant. Predictability of government action has therefore become a major determinant of risk.

The third channel was relative price changes. The dramatic spike in commodity prices (especially food and energy) was reversed. This ameliorated a twin challenge in most developing countries of dealing with the impact of the commodity price spike on the poor and on inflation. Beyond that, at the country level, those who have gained and lost depends on whether a particular country is a net importer or exporter of commodities.

The commodity price spike and fall brought into focus an important policy issue. Large relative price swings have very important distributional consequences across countries and across subsets of the population within countries. These need to be addressed as part of creating a better managed and more stable global economic system that people will support. [for further reference, see part IV of the Commission on Growth and Development: The Growth Report [2]].

Where Are We Now?

On the real economy side, in the advanced countries and globally, growth has gone negative or slowed dramatically. Global growth is projected to be negative in 2009 for the first time since World War II. Trade has collapsed. While there are some signs that the downward momentum may be slowing, the real economies have not bottomed out and are unlikely to do so in 2009 and perhaps well into 2010.

The advanced countries financial systems have shown some recent signs of improvement, though they are still functioning on life support. There are signs that credit is easing and risk spreads are declining somewhat from very high levels. But that is certainly because the government and central banks have a major and expanding role in the financial system. It is too early to say that the system is starting to return to normal. In the US, the Fed and the Treasury have launched a series of initiatives designed to restart the markets in securitized assets, clarify values, remove the transparency fog surrounding the balance sheets of major financial institutions, and as necessary recapitalize banks and other systemically important institutions, probably by becoming a major (or the sole) owner of some of them. Progress on this front from a policy point of view is relatively recent and it is too early to tell the extent to which they will be sufficient to jump start the sequential healing process and a return to normal functioning.

The US savings rate is rising, a part of the disorderly unwinding of global imbalances. Asset prices remain volatile and it is too early to tell if they have stabilized. It is clear however, that the financial system and the real economy will not return to their previous configurations. Even absent major and likely changes in regulation and oversight, there will be a “new normal”. Global growth in the future will be driven by a different portfolio of saving and investment rates and levels across countries.

The Growth Commission Workshop Meeting And Supplementary Report On The Financial And Economic Crisis

The Commission on Growth and Development is meeting one more time in late April in conjunction with a two day workshop, to consider issues related to the financial and economic crisis and its aftermath. The intent is to produce a special report, additional to the Commission report [3] which came out in May 2008. This special report will likely deal with three broad sets of issues.

One set has to do with post-crisis, the challenge of creating more effective regulatory and oversight structures (domestically and internationally) that reduce the risk of instability and the likelihood that the instability spreads quickly to the entire global system. A second set of issues has to do with crisis response. Are there ways when instability and malfunction occur, to limit the damage and disrupt the transmission channels? Further, can some of this capability be created in advance so that it can be deployed quickly? There is obviously a third issue: are the conditions needed to bring the patient back to health and prosperity being met? And if not, what else do we need to do?

The Commission anticipates that there will be a process overseen by the G20 designed to develop proposals for a different global financial architecture, regulatory and oversight structure. Our intention is to have the augmented Commission report contribute to that process with particular attention to the needs and interests of developing countries, some of whom are represented in the G20 itself and most of whom are not.

As we approach the workshop and the Commission meeting and discussion of these issues, we invite broader comment, input and discussion on the BLOG.

Like many members of the Commission and participants in the workshop, I have been thinking and writing about the financial and economic crisis under the headings of causes, crisis dynamics and policy responses, and post crisis reform. A link to my articles will be published on this blog, and I look forward to your comments."

as investors demanded higher yields to lend to the government for longer periods

TO BE NOTED: From Bloomberg:

"Treasuries Little Changed as Fed Readies Purchases of Debt

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By Dakin Campbell and Wes Goodman

April 13 (Bloomberg) -- Treasuries were little changed as the Federal Reserve prepared to buy U.S. government securities today and tomorrow in an effort to cut borrowing costs.

Investors seeking safety during the first global recession since World War II increased holdings of Treasury and agency debt to record levels, a survey of fund managers by Ried, Thunberg & Co. shows. Government and central bank reports this week will show U.S. retail sales rose in March, while a drop in factory production and slower inflation indicate the recession isn’t over, according to surveys of economists by Bloomberg.

“We traded off under the weight of supply last week,” said Martin Mitchell, head of government bond trading at the Baltimore unit of Stifel Nicolaus & Co. “Absent supply, the market will tend to drift lower in yield.”

The yield on the 10-year note rose one basis point to 2.93 percent as of 8:15 a.m. in New York, according to BGCantor Market Data. The price of the 2.75 percent security due February 2019 fell 1/32, or $0.31 per $1,000 face amount, to 98 14/32. U.K. trading of Treasuries was closed today for the Easter holiday, the Securities Industry and Financial Markets Association said.

Fed Buying

Ten-year yields will be in a range of 2.5 percent to 3 percent through the middle of the year, according to Kei Katayama, who oversees $1.6 billion of non-yen debt in Tokyo as leader of the foreign fixed-income group at Daiwa SB Investments Ltd., part of Japan’s second-biggest investment bank. The figure will fall to 2.75 percent by June 30, according to a Bloomberg survey of banks and securities companies with the most recent forecasts given the heaviest weightings. The yield has averaged 4.24 percent for the past five years.

The central bank plans to buy Treasuries due from March 2011 to April 2012 today and from September 2013 to February 2016 tomorrow, according to its Web site. The Fed has more than doubled the size of its balance sheet to $2.09 trillion in the past year by purchasing financial assets including Treasuries in an effort to spur growth.

Investors increased Treasury and agency holdings to 45 percent of their portfolios, matching the all-time high set in October 2002, according to Ried Thunberg, a research company in Jersey City, New Jersey. Agency debt is comprised mostly of securities sold by Fannie Mae and Freddie Mac, the two largest providers of funds for mortgages.

Decline Predicted

U.S. bonds may still fall, the survey showed. An index measuring investors’ outlook for Treasuries through the end of June declined to 43 for the seven days ended April 9 from 44 in the previous week. A reading below 50 means investors expect prices to drop. Ried Thunberg surveyed 25 fund managers controlling $1.35 trillion.

China, the largest holder of U.S. debt outside the nation, should buy more short-maturity U.S. Treasuries than long-term notes, the Oriental Morning Post reported today, citing a former adviser to the People’s Bank of China.

The government should “adjust the maturity structure, and keep asset and currency structures basically unchanged,” Li Yang said in Beijing, the Chinese-language newspaper reported.

Foreign holdings of Treasury bills surged to a record $486.9 billion in January from $207.1 billion a year earlier, according to the Treasury Department. Shorter-maturity bills tend to follow central bank interest rates while bonds are influenced more by inflation.

Yield Curve

The difference between two- and 10-year yields widened to 1.96 percentage points from 1.25 percentage points in December as investors demanded higher yields to lend to the government for longer periods.

Fed purchases have created a Treasury market “bubble” that may keep growing, said Jim Rogers, an investor and author of the book “Hot Commodities.” The Fed, like the Bank of Japan before it, is supporting government debt, he said.

“In Japan, long-term bonds were yielding one half of one percent at one time,” Rogers said on Bloomberg Television in an interview from Singapore, where he lives. “This can go to absurd levels, and bubbles usually do.”

Japan’s 10-year yields, little changed today at 1.46 percent, fell to 0.43 percent in June 2003, the lowest since Bloomberg data tracking the figure began in 1985.

Thirty-year mortgage rates rose to 4.87 percent in the seven days ended April 9 from 4.78 percent the week before, which was the lowest since Freddie Mac, the McLean, Virginia- based mortgage-finance company, began tracking the figure 37 years ago. Rates are 1.97 percentage points more than U.S. 10- year yields, widening from 1.46 percentage points two years ago.

TED Spread

Yields suggest U.S. credit markets haven’t fully recovered after last year’s decline.

The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, narrowed to 95 basis points from 96 basis points on April 10. The spread, which reached 4.64 percentage points in October, was about 36 basis points 24 months ago.

U.S. retail sales rose 0.3 percent in March, according to the median estimate in a Bloomberg News survey before the Commerce Department’s report tomorrow. Industrial production dropped 0.9 percent, the 14th decline in the last 15 months, figures from the Fed on April 15 may show, according to a separate Bloomberg survey.

The Treasury Department has ordered General Motors Corp. to prepare for a bankruptcy filing by June 1, the New York Times reported, raising speculation it will default on its bonds. The report cited people with knowledge of the plans.

Cost of Living

Treasuries fell last week as the government sold $59 billion of notes to help fund President Barack Obama’s spending plans. Government securities dropped 1.2 percent in April, extending a 1.4 percent loss in the first quarter that marked the worst start to a year since 1999, according to Merrill Lynch & Co.’s U.S. Treasury Master Index.

Fed Chairman Ben S. Bernanke’s efforts to spur growth may result in a higher cost of living, said Allan Meltzer, the central bank historian and professor of political economy at Carnegie Mellon University in Pittsburgh.

Inflation “will get higher than it was in the 1970s,” Meltzer said. At the end of that decade, consumer prices rose at a year-over-year rate of 13.3 percent. Rising costs erode the value of the fixed payments from bonds.

The difference between rates on 10-year notes and Treasury Inflation Protected Securities, which reflects the outlook among traders for consumer prices, was little changed at 1.35 percentage points from near zero at the end of 2008. The average for the past five years is 2.25 percentage points.

The U.S. consumer price index probably fell 0.1 percent in March from a year earlier, according to economists surveyed by Bloomberg before the Labor Department report on April 15. In February, the index rose at a year-over-year rate of 0.2 percent."

signaling the freeze in credit markets that began 18 months ago is starting to thaw

More good news on the possible diminution of the fear and aversion to risk. As I've said, the TED and VIX are both down, and what a lovely couple they are. From Bloomberg:

"By Gavin Finch and Matthew Brown

Jan. 13 (Bloomberg) -- The premium that banks pay to borrow money compared with the U.S. Treasury narrowed to the least in five months, signaling the freeze in credit markets that began 18 months ago is starting to thaw.( YES )

The difference between the London interbank offered rate, or Libor, that banks say they charge each other for three-month loans in dollars and the yield on the three-month Treasury bill, fell 12 basis points to 98 basis points today. The so-called TED spread last closed below 100 basis points Aug. 15. Dollar Libor dropped to 1.09 percent today, the lowest level since June 2003.

“It’s slowly but surely improving,” said Padhraic Garvey, head of investment-grade debt strategy at ING Groep NV in Amsterdam. “We’re going through a good period now with regards to Libors.”( YES )

Central banks around the world sought to combat the seizure in credit markets by cutting interest rates and lending record amounts of cash directly to banks. President-elect Barack Obama said Jan. 12 he wants the second half of a $700 billion financial- bailout fund available to him as “ammunition” in the event of an economic emergency and promised to direct more of the money to small businesses and homeowners.

The falling cost of borrowing for banks is luring some companies back to the credit markets. Bad Homburg, Germany-based Fresenius SE, the owner of the world’s largest kidney dialysis provider, is seeking to become the first sub-investment-grade company to sell bonds for 18 months, people familiar with the matter said yesterday.( GOOD )

‘Crisis Territory’

Libor, the benchmark for $360 trillion of financial products worldwide, is set by a panel of banks in a survey by the BBA typically before noon each day in London.

The three-month dollar Libor is still 84 basis points above the upper end of the Federal Reserve’s target rate for overnight loans, compared with an average of 12 basis points in the year before the crisis began. The spread was 332 basis points on Oct. 10, less than a month after the collapse of Lehman Brothers Holdings Inc.( THE CAUSE )

Libors “are still very elevated,” ING’s Garvey said. “In absolute terms, they are still in crisis territory.”( TRUE )

While money-market strains may be easing, investors are still seeking the safety of the shortest-dated U.S. government debt. The rate on three-month Treasury bills was 11 basis points today, from six basis points yesterday. It was at 3.15 percent a year ago.

Economists and strategists predict the declines in three- month dollar Libor have run out of steam and the rate will be at 1.12 percent by the end of the first quarter, according to a Bloomberg survey. Implied forwards suggest( THAT'S ALL IT IS ) the rate will rise back up to 1.78 percent in the same period.

In a further sign that banks remain wary of lending to each other, overnight deposits placed with the European Central Bank by financial institutions held at more than 300 billion euros ($398 billion) for second day yesterday. The daily average in the first eight months of last year was 427 million euros.( EUROPE IS BEHIND US )

To contact the reporters on this story: Gavin Finch in London at gfinch@bloomberg.netMatthew Brown in London at mbrown42@bloomberg.net"

"But the TED spread has declined significantly over the last 6 weeks."

On Econbrowser, some good news from James Hamilton:

"Signs of a thaw

Yes, I saw the discouraging headlines. But I also see signs of hope in last week's economic news.

Let me begin by acknowledging the awful employment news. This was undeniably grim( BUT IT HAS TO DO WITH THE PROACTIVITY RUN, NOT THE CALLING RUN. ), though popular descriptions that BLS had reported the biggest job loss in any calendar year since 1945 are perhaps unnecessarily alarmist. Population growth would naturally mean that both job gains and job losses would be expected to be bigger absolute numbers than they used to be, and there's no special reason to look at calendar years rather than all 12-month intervals. The graph below shows that in percentage terms, the employment decline so far is similar to what we see in a typical recession.( TRUE )

Year-over-year percentage change in seasonally unadjusted nonfarm payroll employment, from FRED.

But my primary concern has not been unemployment per se but instead the dysfunctional financial market that produced it. And here there are some encouraging developments. The TED spread is the difference between the 3-month LIBOR rate (an average of interest rates offered in the London interbank market for 3-month dollar-denominated loans) and the 3-month Treasury bill rate. Its spike up last fall was a very troubling indicator of perceived bank risk, flight to quality, and frictions in the interbank lending market. But the TED spread has declined significantly over the last 6 weeks.( AS HAS THE VIX )

TED spread, as obtained from Bloomberg on Jan 10.

The gap between the A2/P2 and AA rates, which measures how much more riskier (but still prime) nonfinancial commercial firms must pay to borrow compared with safer borrowers, had also reached scary heights and has also come down significantly.( A SIGN OF A DIMINUTION IN THE FEAR AND AVERSION TO RISK. )

Source: Federal Reserve.

These may be among the developments that persuaded the Federal Reserve it could begin the process of contracting its now enormous balance sheet( A GOOD POINT ). The assets of the Federal Reserve had exploded from $940 billion at the beginning of September to $2.3 trillion by the end of the year, as the Fed expanded operations such as its Term Auction Facility, which offered term loans directly to banks at much more favorable rates than the previously spiking LIBOR, and the commercial paper lending facility, which propped up the commercial paper market with direct purchases. The Fed apparently felt comfortable enough with the current situation to reduce these balances by $126 billion during the week ended January 7. More than half of that reduction came from a reduction in the volume of term auction credit outstanding( GOOD NEWS ).

Federal Reserve assets in billions of dollars. Data source: Federal Reserve Release H.4.1.

This reduction in assets was necessarily matched by an equal reduction in liabilities; for details on how this works see my earlier description of the Federal Reserve balance sheet. The primary change last week was a reduction in the Treasury's accounts with the Fed.

Federal Reserve liabilities in billions of dollars. Data source: Federal Reserve Release H.4.1.

The TED spread and A2/P2-AA spread have often exhibited a pattern of temporary respite followed by a resurgence of perceived risk, and the same could certainly happen again. Nevertheless, I read the recent numbers as clearly encouraging."

I see both the recent TED and VIX movements as a sign of the diminution of the fear and aversion to risk due to the Calling Run. The Proactivity Run is still going.

“Bubbles are born of greed; this is fear,”

More on the Flighty To Safety and a possible bubble on Bloomberg:

By Daniel Kruger

Jan. 1 (Bloomberg) -- Treasuries recorded their biggest annual gain since 1995 as falling stocks and frozen credit markets drove investors to the relative safety( FLIGHT TO SAFETY ) of U.S. government debt.

Yields of all maturities touched record lows as financial firms’ losses in the credit crisis exceeded $1 trillion and policy makers made unprecedented moves to rescue the country from recession. Foreign companies and institutions increased their stake in U.S. government debt by 29 percent in the first 10 months of the year, Treasury Department data shows.

“It’s one heck of a run for 2008,” said George Goncalves, chief Treasury and agency strategist with Morgan Stanley, one of 17 primary dealers that trade with the Fed. “The capital markets are going to be about the Treasury market next year.”

Treasuries returned 14 percent in 2008, according to Merrill Lynch & Co.’s Treasury Master index. It was the best performance since 1995, when they rose 18.5 percent after the Federal Reserve began lowering its benchmark interest rate from 6 percent. The Standard & Poor’s 500 Index lost more than 38 percent for the year, the most since 1937.

The U.S. economy entered a recession in December 2007, the National Bureau of Economic Research said this month. The Cambridge, Massachusetts-based group sets dates on U.S. business cycles. The slump began about four months after financial markets started seizing up as rising defaults on subprime mortgages began to affect the value of other assets in the credit markets.

‘Most Trying Year’

The Fed cut its target rate for overnight lending between banks to a range between zero and 0.25 percent, from 4.25 percent at the start of the year. It rescued insurer American International Group Inc. and committed $8.5 trillion to sustain the economy.

The Treasury put mortgage-finance companies Fannie Mae and Freddie Mac into conservatorship, purchased bank stock and bailed out automakers General Motors Corp. and Chrysler LLC. It spent half of a $700 billion bank-rescue fund, the Troubled Asset Relief Program, authorized by Congress.

Policy makers let Lehman Brothers Holdings Inc. collapse in September, sparking a panic about the safety( GUARANTEES. BRAVO! THAT'S IT. ) of financial institutions.

“This has been the most trying year that most people will ever live through,” Ray Remy, head of fixed income in New York at Daiwa Securities America Inc., another primary dealer, said yesterday. “Time to end it.”

The tumult is unlikely to be over. The U.S. said it may sell as much as $2 trillion in debt to fund various bailout and stimulus packages and the U.S. budget shortfall.

‘Tons of Supply’

The year will open with the auction of $8 billion of 10- year inflation-indexed securities on Jan. 6, a sale of three- year notes on Jan. 7 and an auction of 10-year notes Jan. 8; the size of the note sales has yet to be announced.

“Next week we have tons of supply, so the market has to pay attention to that,” Remy said. “As soon as we walk in here on Monday, I would imagine the selling will start.”

Demand for Treasuries last year reached the “bubble” phase seen in technology stocks in 2000 and real estate in 2006, David Rosenberg, chief North American economist at Merrill Lynch, wrote in a research note Dec. 1. He forecast the 10-year note’s yield could fall below 2.3 percent, which it did for the first time barely two weeks later.

“This next leg down in yield will undoubtedly represent the classic mania-turn-to-bubble phase( I HAVE TO SAY THAT I AGREE ),” New York-based Rosenberg wrote.

With the economy losing 1.9 million jobs in the first 11 months of 2008, according to Labor Department data, others saw different factors behind the record low yields.

‘Nowhere Else to Run’

“Bubbles are born of greed; this is fear( CORRECT. FEAR AND AVERSION TO RISK AND THE ACCOMPANYING FLIGHT TO SAFETY. ),” T.J. Marta, a fixed-income strategist at RBC Capital Markets in New York, said this week. The firm is the investment-banking arm of Canada’s biggest lender. “There’s nowhere else to run( A CALLING RUN ) at this point. This is a lot more like Japan in the 1990s or the U.S. in the 1930s than the U.S. in the 1980s or 1970s.”

Foreign entities hold $3.04 trillion in U.S. securities, about 52 percent of marketable Treasury debt. That’s up 29 percent from $2.35 trillion they owned the end of 2007, according to Treasury Department data.

The Fed’s custodial holdings of Treasuries for foreign entities including central banks rose 37 percent in 2008 to $1.68 trillion as of Dec. 24, the largest jump since at least 1984.

The central bank’s custodial holdings of so-called agency securities, including mortgage securities issued by Fannie Mae and Freddie Mac, fell( ONLY IMPLICIT GUARANTEES ) 0.6 percent to $825 billion, the first decline since at least 2001 when the Fed began reporting the data. Agency holdings had risen between 22.7 percent and 53.3 percent in each previous year.

TED Spread

Yields indicate the Fed’s interest-rate reductions have made banks more willing to lend than earlier in 2008. The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, narrowed to 1.35 percentage points yesterday from 4.64 percentage points in May. That was the most since Bloomberg began compiling the data in 1984.

Ten-year Treasury note yields will climb to 3.4 percent by the end of 2009, according to a Bloomberg survey of 58 economists, with the most recent forecasts given the heaviest weighting.

The Securities Industry and Financial Markets Association recommended that Treasuries markets be shut around the world today for the New Year’s Day holiday."

"A lower TED spread means less fear and more lending. "

From Simit Patel on the Trader's Narrative:

Banks Have Started Lending and the Money Supply is Growing

---

Monitoring the money supply can be a useful tool in understanding "the big picture" of what is going on in the economy. Towards the end of the summer/early fall of 2008, we saw money supply indicators, like MZM, contract. This was the result of deleveraging; in our debt-based economy, in which all money originates out of debt, paying off debts reduces the money supply -- while the issuance of debts increases money supply. Thus, the combination of deleveraging (paying off debts) with a decrease in bank loans resulted in the money supply contracting, the dollar strengthening, and asset prices falling -- all characteristics of deflation.

These trends seem to be reversing. The chart below tracks MZM; note the recent spike upwards.

This image has been resized. Click this bar to view the full image. The original image is sized 630x378.

Likewise, the TED spread -- an indication of fear and risk in the market( TRUE ), and whether or not banks are lending -- has been declining. A lower TED spread means less fear and more lending( I AGREE ). The increase in money supply makes sense with a lower TED spread. Both run contrary to reports from much of the media that banks are still unwilling to lend( I AGREE ).

The chart below illustrates the TED spread; note it has declined significantly from its peak in October, when the psychology of fear was at its peak( I AGREE ).

This image has been resized. Click this bar to view the full image. The original image is sized 610x464.

In terms of financial markets, we've seen the dollar weaken of late, while gold has been rising. This is consistent with the behavior of MZM and the TED spread.

Disclosure: Long gold."

Good news.

"There are two kinds of liquidity: market liquidity, and funding liquidity."

Interesting post on liquidity on Vox by Lasse Heje Pedersen:

"There are two kinds of liquidity: market liquidity, and funding liquidity.

• A security has good market liquidity if it is “easy” to trade, that is, has a low bid-ask spread, small price impact, high resilience, easy search (in OTC markets).
• A bank or investor has good funding liquidity if it has enough available funding from its own capital or from (collateralised) loans.

With these notions in mind, the meaning of liquidity risk is clear.

• Market liquidity risk is the risk that the market liquidity worsens when you need to trade.
• Funding liquidity risk is the risk that a trader cannot fund his position and is forced to unwind.

For instance, a levered hedge fund may lose its access to borrowing from its bank and must sell its securities as a result. Or, from the bank's perspective, depositors may withdraw their funds, the bank may lose its ability to borrow from other banks, or raise funds via debt issues."

God, I love clear explanations.

"Liquidity generally varies over time and across markets, and currently we are experiencing extreme market liquidity risk. The most extreme form of market liquidity risk is that dealers are shutting down (no bids!), which is currently happening in a number of markets such as those for certain asset-backed securities and convertible bonds. We are also experiencing extreme funding liquidity risk since banks are short on capital, so they need to scale back their trading that requires capital, and also scale back the amount of capital they lend to other traders such as hedge funds, that is, hedge funds now face higher margins. In short, if banks cannot fund themselves, they cannot fund their clients.
The two forms of liquidity are linked and can reinforce each other in liquidity spirals where poor funding leads to less trading, this reduces market liquidity, increasing margins and tightening risk management, thus further worsening funding, and so on."

A doppio, if you will. Or even if you won't. Still very clear.

"The higher required return in times of higher market liquidity risk leads to a contemporaneous drop in prices, according to this theory, consistent with what we are seeing in the current marketplace. An overview of the liquidity literature is available here."

Still clear.

"The trigger of the crisis was the bursting of the housing bubble, combined with a large exposure by the levered financial institutions. This led to significant bank losses with associated funding liquidity problems. This started the systemic liquidity spirals. As banks’ balance sheets deteriorated, they had to de-lever. To do this, they:

• started selling assets;
• hoarding cash;
• tightening risk management.

This put stress on the interbank funding market (as measured e.g. by the TED spread, see slides) as everyone was trying to minimise counterparty exposures.

Banks’ funding liquidity problems quickly spread. Other investors, especially those that rely on leverage such as hedge funds, face funding risk when banks become less willing to lend, they raise margins, and, in the extreme, when the banks fail as Lehman did.

When banks such as Bear Stearns and Lehman started to look vulnerable, their clients risked losing capital or having it frozen during a bankruptcy, and they started to withdraw capital and unwind positions, leading to a bank run.

This funding liquidity crisis naturally lead to market illiquidity with bid-ask spreads widening in several markets, and quoted amounts being reduced by dealers with less available capital. This market illiquidity, and the prospect of further liquidity risk, scared investors and prices dropped, especially for illiquid assets with high margins."

I love this article. I wish I could write something like this. It reminds me of Derivative Dribble.

This is the downward liquidity spiral as illustrated in the chart.


Love charts. I got a great map from Kedrosky to post.

"The crisis spreads to other asset classes

The crisis has been spreading across asset classes and markets globally. There are currency crashes as traders unwind carry trades and lose faith in weak currencies. Further, as an example of the gravity of the liquidity crisis, the “Covered Interest Rate Parity” – the most basic arbitrage condition in the world’s thickest market (foreign exchange) – currently fails to hold even for the major currencies. This must mean that no one can arbitrage because no one can borrow uncollateralised, no one has spare collateral, and no one is willing to lend – arbitrage involves both borrowing and lending.

The increased risk and illiquidity has also lead to a spike in volatility, contributing to the higher margins. Further, correlations across assets have increased as everything started trading on liquidity.

The crisis spreads to Main Street

Clearly, the crisis is having a significant effect on the real economy as homeowners see their property value deteriorate, consumers access to borrowing is reduced, main street companies face higher cost of equity and especially debt capital and a lower demand for their products, unemployment goes up, etc."

I really can't paraphrase this guy.

"If the problem is a liquidity spiral, we must improve the funding liquidity of the main players in the market, namely the banks. Hence, banks must be recapitalised by raising new capital, diluting old equity, possibly reducing face value of old debt. This can be done with quick resolution bankruptcy for institutions with systemic risk, i.e. those causing liquidity spirals.

Further, we must improve funding markets and trust by broadening bank guarantees, opening the Fed's discount window broadly (giving collateralised funding with reasonable margins), and ensuring the Commercial Paper market function. Further, risk management must acknowledge systemic risk due to liquidity spirals and the regulations must consider the system as a whole, as opposed to each institution in isolation.

If we have learned one thing from the current crisis, it is that trading through organised exchanges with centralised clearing is better than trading over-the-counter derivatives because trading derivatives increases co-dependence, complexity, counterparty risk, and reduces transparency. Said simply, when you buy a stock, your ownership does not depend on who you bought it from. If you buy a “synthetic stock” through a derivative, on the other hand, your ownership does depends on who you bought it from - and that dependence may prevail even after you sell the stock (if you sell through another bank). Hence, when people start losing confidence in the bank with which they trade, they may start to unwind their derivatives positions and this hurts the bank’s funding, and a liquidity spiral unfolds."

This part about clearinghouses or exchanges I've already understood, but not this clearly.

"In the debate about how to solve the crisis and prevent the next one, it has been suggested that policymakers should ban short selling and impose a transaction tax on stocks. I believe that neither is a good idea. First, short sellers bring new information to the market, increase liquidity, and reduce bubbles (remember the housing bubble started this crisis) so preventing this can be very costly and prohibiting short sales does not solve the general funding problem. While temporarily banning new short sales of financial institutions can be justified if there is risk of predatory trading, this is rarely a good idea since short sellers are often simply scapegoats when bad firms go down fighting. (See here for how shortselling works.)"

I thought that this was window dressing at the time. However, he claims that it's not harmless.

"Second, a transaction tax on stocks is problematic for several reasons, most importantly because it moves trading away from the official exchanges and into the derivatives world, thus increasing the systemic risk. One of the main arguments in favour of such a transaction tax is that it helps to prevent bubbles, but there is little or no empirical evidence to support this. For instance, in the UK there is a 0.5% tax on trading stocks and a higher tax on trading real estate (up to 4%), but the UK arguably had one of the larger housing bubbles. Further, with a depressed and vulnerable stock market, this does not appear to be the best time to introduce transactions taxes related to potential stock price bubbles in the far future.

To see the problem, consider what happened in the UK due to their transaction tax. The professional investors such as hedge funds found a way around the regulation by executing their trades using derivatives rather than trading stocks directly (while individual investors are unable to avoid the tax). Specifically, in the UK hedge funds typically trade via swaps with counterparties such as investment banks to avoid the transaction tax. There is little doubt that this would also happen in the US if such a tax was introduced here. This would increase counterparty dependencies, systemic risk, and worsen risk management spirals as discussed above.

Another serious problem with the tax is that it lowers liquidity in the marketplace as trading activity may move abroad, move into other markets, or disappear. On top of these distortions to the stability of the financial system, this tax may raise capital costs for Main Street firms because of higher liquidity risk in US financial markets. Indeed, buying US stocks will be less attractive to investors – domestically and internationally – if they must pay a tax to buy and if they anticipate reduced liquidity in the future when they need to sell.

This could make it harder for US corporations to raise capital. And, the importance of being able to raise capital is what this crisis is all about."

I keep hearing about a Tobin Tax, but I don't get it. Here's some good reasons why.

"Market liquidity risk is an important driver of security prices, risk management, and the speed of arbitrage. And the funding liquidity of banks and other intermediaries is an important driver of market liquidity risk. Liquidity crisis are evolve through liquidity spirals in which losses, increasing margins, tightened risk management, and increased volatility feed on each other. As this happens, traditional liquidity providers become demanders of liquidity, new capital arrives only slowly, and prices drop and rebound."

I've printed almost entirely because I want to keep it.

TED Spread

On the TED spread, the necessary blog Calculated Risk:

"Here is the TED Spread from Bloomberg. The TED spread hit a record 4.13 this morning. This is far above the highs reached during the previous waves of the credit crisis.

Note: the TED spread is the difference between the LIBOR interest rate and the three month T-bill. Usually the TED spread is less than 0.5%. The higher the spread, the greater the perceived credit risks (compared to "risk free" treasuries)."

Read the whole post.