Shark Tracker and the Sex Police

Fair warning: This post has absolutely nothing to do with anything except what I do when I goof off from covering finance. Feel free to skip it.

Holiday doldrums: I've been working on a brief overview of the most recent BIS Quarterly Review (that's Bank for International Settlements - sort of a global central bank and international financial regulatory organization) but I'm having trouble making myself finish it. The review is 81 pages of excellent, but rather dry analysis, of statistics and global trends in financial markets, bank business models, foreign currency reserves, and undiversifiable risks arising from securitizations. It's not actually as boring as it sounds (yes it is) but it's time consuming to pull out the interesting bits and connect them to potential future market moves. Which is the reason I exist. Until I can get that organized, here are a couple of time wasters that you may find entertaining if you're stuck on the trading floor this week, while everyone who makes more money than you is on the beach in St. Bart's or skiing in Aspen.

Great white sharks roaming the mid-Atlantic: Like most sane, rational people (who read Jaws as a child and spends way too much time watching the Discovery Channel), I have a pronounced fear of sharks. Specifically, being bitten in half below the waist (haha) by a great white shark while floating walrus-like in the swells off the beach. Or in Lake Michigan (you don't know).

My exaggerated fears led to a life-long, land-based interest in these magnificent animals. OCEARCH has been researching and tagging great white sharks and other apex predators to provide protection for the sharks, and education for the public and other scientists about these deeply mysterious creatures. Thanks to these incredible (and incredibly brave) researchers, I also have a new appreciation for just how often they are probably cruising the surf nearby, not eating me.

Courtesy of Shark Tracker, above is the 2-year tracking history of Mary Lee, a 16 ft, 3,500 lb great white shark who spends most of her time cruising the beaches of the mid-Atlantic, with the occasional vacation to Bermuda. If you want a sincere appreciation for just how big a 16 ft great white is, take a look at the pictures of Mary Lee being tagged on the site.

There are a lot of sport and commercial fishermen among my family and friends, and their encounters with or sightings of great whites have been exceptionally rare, but awe inspiring. Personally I hope to never see one in it's natural habitat or kept in captivity, but I applaud the scientists at OCEARCH and elsewhere who continue to respectfully learn more about them an share that knowledge with us.

Nostalgia on New Year's Eve: There are a lot of stupid things you can do in your 20s, and I endeavored to do most of them. The more reckless of these pursuits required spending a lot of time at bars, listening to local bands. When I was in Chapel Hill in the 90s, one of the best of these was the Sex Police. Alternative angst was not their style: the Sex Police were raucous, ridiculous, energetic and had a horn section.

They are reuniting for New Year's Eve show at the Cat's Cradle. Although I doubt I will find myself there in body, I will be there in spirits.

Hope everyone has a safe and happy turn into 2015. Then back to business as usual.

Bank Buying of Treasuries Helped Drive Yields Lower in 2014

Update: This is a follow-up on our Federal Reserve flow of funds post from Tuesday, December 9th, since data was updated on Thursday, December 11th. Please see that post, The Rest of the World Still the Dominant Treasury Investor for background.

The 2014 rally. Treasuries have persistently rallied throughout 2014 (see chart) despite:

1. Improving economic data in the US; and
2. The Fed winding down its own Treasury purchases that were part of QE, as of the end of October.

The 30yT has rallied almost 125 bp YTD from just under 4.00% to 2.75%, and the 10yT yield has dropped by 90 bp from 3.00% to 2.10%. In fact, as we head into the end of 2014 the rally has accelerated while the two lynchpins of the economy - employment and consumer spending - are showing signs of perhaps blockbuster strength.

Global demand for Treasuries remains high due to dollar strength and economic weakness outside US. We revisit the flow of funds data to see what sectors have been large marginal buyers of Treasuries this year. It is an obvious conclusion from the charts below of quarterly flows (seasonally adjusted annualized rates) that the "rest of the world" has long been the largest marginal buyer and holder of Treasuries. The "rest of the world" is a catch-all for foreign demand; in the Treasury universe it is dominated by demand from foreign central banks and other foreign official accounts.

Duration extension by foreign central banks. It is important to note that in the 2Q and 3Q of 2014, foreign buyers actually sold or ran-off nearly $300 bn in Treasury bills and bought close to $800 bn of longer-term Treasury securities, for net buying of ~$500 bn. (This breakdown is available in the complete FoF data, though we don't show it above.) That duration extension no doubt had a sizable impact on the level of rates across the curve.

US banks increase Treasury buying to satisfy regulatory requirements. The other, arguably more important trend in 2014, has been the pick-up in Treasury demand from US banks and other depository institutions. Net buying by US banks initially jumped higher in 4Q 2013 and has remained strong, rising again in 3Q 2014. This buying is the result of new regulatory rules and standards for banks - most embedded in Basel III - that have been announced and are gradually being phased-in. The most important of these are the liquidity coverage ratio and liquidity risk monitoring tools, both of which "encourage" banks to significantly increase their holdings of so-called "high quality liquid assets," of which the safest of these is Treasuries.

It has long been speculated by myself and others that, over time, the increased Treasury buying by banks due to regulatory requirements would put sustained downward pressure on rates. That has clearly materialized in 2014. I don't know how close banks are to satisfying the new liquidity requirements, though there are several groups that track and estimate such measures (The Clearing House and the BIS are two such organizations). I will try to find estimates from them and post later this week.

A flat scenario for 2015? One takeaway here is that, at least on the part of banks, the outright level of Treasuries that they hold has been increased dramatically over the past year - from $276 bn to $442 bn - (see chart above) and this will be sustained. Once banks reach the appropriate liquidity thresholds, the growth in the level and flows is likely to moderate, but as securities mature they will need to be replaced, so the overall net flows from banks will probably be positive going forward, keeping some overall pressure on Treasury yields.

Foreign buying of Treasuries over the longer-term is no doubt the biggest swing factor. Although foreign official accounts are generally buy and hold, any pull back in Treasury buying on the margins - due to either a strengthening global economy or diversification away from US dollar assets - will be felt in Treasury yields. Although it's possible that there could be a moderation of foreign and bank demand in 2015, we suspect it will persist at least for the next two to three quarters.

Would the Fed invert the curve? In our minds (ok, my mind) that leaves the following open question: what if the 10yT yield hits a ceiling at ~2.50% as the Fed begins to raise rates in 2015? Does that effectively cap the path of short term interest rates for this cycle given that it may stop the Fed from deliberately inverting the yield curve? Is it possible that the path of short term rates rises from 0.25% to 2.00% and stops there? I suppose that really depends upon what happens with inflation in the US and globally, but it seems to be getting more and more difficult to project inflation to rise substantially in the near term.


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Good Riddance to (most of) the Swaps Push-Out Rule

Congressional sausage making. Hopefully, by tomorrow evening (Friday, December 12th, 2014), both chambers of Congress will have successfully avoided yet another unpopular government shutdown by having passed the Consolidated and Further Continuing Appropriations Act, 2015. The CRomnibus (Congressional slang for "continuing resolution omnibus") spending bill will fund the government through September 30, 2015, the end of the 2015 fiscal year. This bill - like virtually all spending bills before it - is crammed with a variety of amendments reflecting diverse legislative priorities, ranging from big to petty and cutting across all swaths of the political spectrum, in order to secure enough votes for passage.

Pruning Dodd-Frank. One of the "big" inclusions in the bill - that is creating something of a populist furor in the media - is an amendment that would scale back section 716 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly referred to as the "swaps push-out rule". Our favorite kemosabe, Senator Elizabeth Warren, is out proselytizing that scaling back the swaps push-out provision will allow "Wall Street to gamble with taxpayer money."

The swaps push-out rule. I suspect that you would rather poke pins in your own voodoo doll than read Section 716 of Dodd-Frank. Instead, we excerpt from one of many excellent legal summaries of the provision, this one from Cadwalader (edited for brevity):

One of the most contentious provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act1 (the “Dodd-Frank Act”) is Section 716 – commonly referred to either as the “Lincoln Amendment” after its principal proponent, Senator Blanche Lincoln of Arkansas, or alternatively by its functional name, the “swaps push-out rule.” The Lincoln Amendment effectively forbids FDIC-insured institutions and other entities that have access to Federal Reserve credit facilities – including banks, thrifts, and U.S. branches of foreign banks – from acting as a “swap dealer” except in certain limited circumstances, thus requiring such institutions to “push out” most swap dealing activities into an affiliate that is not FDIC insured and that does not otherwise access Federal Reserve credit facilities.

Inasmuch as maintenance of FDIC insurance is a requirement for all national banks, all federal thrifts, all state Member banks, and all (if not virtually all) state non-Member banks and state thrifts, Section 716 effectively precludes a bank or thrift from being a “swap dealer” after the effective date of the Lincoln Amendment.

There are some broad exemptions. Businesses and/or trading desks of the following swap products are exempt from the push-out rule:

• Interest rate and foreign currency swaps;
• Swaps involving bank eligible assets, such as agency MBS, marketable corporate grade debt, loans and precious metals;
• Swaps used in bank hedging activities and other risk mitigation.

So what swap businesses are actually prohibited at a bank under the rule? Generally speaking, banks are prohibited from engaging in swaps related to commodities, equities and credit (with a notable exception of investment-grade credit default swaps that are centrally cleared). These swaps businesses must be pushed out to a separately capitalized entity.

Why is the push-out rule controversial? You're going to love this, I promise.

1. Its inclusion in Dodd-Frank was opposed by virtually every banking regulator, the Treasury, and other financial regulatory bigwigs (see: Volcker, Paul) from the time it was initially proposed (in April of 2010). It didn't even have the support of the majority of Democrats. So, how did it get in the bill? 
2. It was put into the bill as a blatant and ultimately unsuccessful attempt to save Blanche Lincoln's (D-AK) senate seat. 

Let's address the regulatory resistance first. Excerpts from a Harvard Law School Forum post authored by lawyers at Davis Polk & Wardwell, titled Transition Period for Swaps Pushout Rule (edited for brevity, formatting added to improve the funny):

The Swaps Pushout Rule has been one of the most controversial provisions of the Dodd-Frank Act. It was opposed by the heads of all three federal banking agencies as well as Paul Volcker. Both Federal Reserve Chairman Ben Bernanke and former FDIC Chairman Sheila Bair said it would increase systemic risk, rather than reduce it. The Swaps Pushout Rule has not improved with age. Indeed, one of the key lessons from the preparation of resolution plans under Title I of the Dodd-Frank Act, and recent simulations of the resolution of a systemically important financial institution under Title II of the Dodd-Frank Act, is that pushing swaps out of insured banks into non-bank affiliates creates an impediment to the orderly resolution of banking groups.

When swaps are held within an insured bank, their value can be preserved for the benefit of the bank’s creditors (including the FDIC’s Deposit Insurance Fund) and the stability of the financial system because the FDIC has the statutory power and incentive to transfer the swaps to a creditworthy third party or bridge bank within one business day after the original bank’s failure, overriding any otherwise applicable rights of counterparties to terminate the swaps. In contrast, counterparties have the right to immediately terminate swaps held within a non-bank affiliate under the Bankruptcy Code, and bankruptcy courts have no power or incentive to override those rights by transferring the contracts to a creditworthy third party or bridge company. Selective termination of swaps by a bankrupt entity’s counterparties typically results in the sort of value destruction and severe market disruption that occurred in the Lehman bankruptcy. As a result, there have been numerous efforts since the enactment of the Swaps Pushout Rule in July 2010 to repeal or significantly modify it.

Editor's update: Sheila Bair has recently reversed her opinion and now thinks that the push-out rule should be kept in its entirety. You can read her opinions here. 

The Treasury also refused to endorse the push-out provision at the time, though current Treasury Secretary Jack Lew has stated that Congress should allow the SEC to finish the rulemaking process before it attempts to dismantle it. 

Swaps push-out as political pandering. It's tough to remember back to the spring of 2010. We were all running around with our financial hair on fire. Dodd-Frank was being constructed, Congressional voting was imminent, but no one knew for certain what was going to be included. Blanche Lincoln's proposal was one of several that was hotly debated in the press.

Excerpts from a May 15, 2010 article (in that notorious bastion of conservative journalism, the New York Times), In Tough Stance, Democrat Finds Few Allies (edited for brevity, formatting added):

The chairman of the Federal Reserve opposes it. The country’s chief banking regulator dislikes it. The secretary of the Treasury has been unsupportive, at best, and Paul A. Volcker — no one’s idea of a best friend to Wall Street — calls it unnecessary. 

Their antipathy is directed at a proposal from Senator Blanche Lincoln Democrat of Arkansas. She wants banks to get rid of their lucrative derivatives operations because they played an outsize role in the financial debacle. And when Wall Street needed a rescue, Mrs. Lincoln says, taxpayers should not have had to bail out bankers’ bad bets.

But just how far Democrats will pull back from an outright prohibition is unclear. Mrs. Lincoln is in a vicious primary campaign. Her opponent has tried to portray her as a Washington insider cozy with Wall Street and big business. If Mrs. Lincoln is seen as having given ground to bankers on derivatives, she could lose her job — and Democrats might well lose the seat to a Republican this fall.

In the month since Mrs. Lincoln offered her proposal, Democrats have played a waiting game. But in that time, opposition has grown and bank lobbyists have fought her plan, what they call the “push out” provision. 

Banks are betting that with the support of the prominent regulators, Democrats will have the political cover to oppose Mrs. Lincoln’s provision without appearing to give in to Wall Street. 

Mrs. Lincoln is adamant in her belief that banks should not be in the business. 

“Banks were never intended to perform these activities, which have been the single largest factor to these institutions growing so large that taxpayers had no choice but to bail them out in order to prevent total economic ruin,” she said this month. 

Editor's aside: I am tempted to parse the sentence above and refute the allegations in it as factually incorrect, misleading, and resorting to the usual chicken-little style hyperbole of politicians, but (a) the argument was 4+ years ago; and (b) she lost the general election in 2010 in a landslide.

The nation’s chief banker disagrees. In a letter last week to several senators, Ben S. Bernanke, chairman of the Federal Reserve, said that “forcing these activities out of insured depository institutions would weaken both financial stability and strong prudential regulation of derivative activities.” 

 Below is an arbitrary calendar of events, after the above article appeared in the New York Times on May 15, 2010.

• Arkansas Democratic primary, May 18, 2010: US Senator Blanche Lincoln (Democrat) 44.5%, Lieutenant Governor  Bill Halter (Democrat) 42.5%, DC Morrison  (Democrat)12.3%

• Arkansas Democratic primary run-off, June 8, 2010: Blanche Lincoln 52%, Bill Halter 48%.

• Dodd-Frank legislative text finalized, June 25, 2010: The Senate-House conference agrees on final legislative text of the Dodd-Frank bill, including Section 716, the "swap push-out provision" as proposed by Blanche Lincoln. 

• General election, November 2, 2010: John Boozman (Republican) 57.9%, Blanche Lincoln 36.9%

Tailoring the swaps push-out rule in CRomnibus. This is actually pretty straightforward. The House is proposing to shrink the swaps push-out rule so it will not apply to equity and commodity swaps. Airlines that want to hedge their jet fuel exposure can do so at reasonable cost at any bank with a relevant swaps desk. So what is still pushed out? From a House of Representatives write-up:

The section would continue to apply to structured finance swaps that are based on an asset-backed security. Retaining coverage of structured finance swaps based on asset-backed securities was intended to address concerns surrounding the well-known derivatives activity of American International Group (AIG) based on mortgage-backed securities which directly contributed to the company's precipitous decline and Federal bailout in the fall of 2008. 

For the record: AIG? NOT A BANK. Problem with their "security based structured finance swaps"? They were based on subprime mortgage securities. It was never the "swaps" at "banks" that were the problem; it was that the underlying collateral was bursting into flames. Congress should have listened to the regulators, because they were right. (I know, I can't believe I said it either.)

We're done here. 

The Rest of the World Still the Dominant Treasury Investors

The data. The Federal Reserve releases its quarterly flow of funds report on Thursday. Officially titled "Z.1 Financial Accounts of the United States - Flow of Funds, Balance Sheets, and Integrated Macroeconomic Accounts," the 175 page report is mind-numbing in a way only government produced documents can be. For those willing to sift through the information - or better yet, hire some economists (or archeologists) to do it for you - the report contains a wealth of high level information about the quarterly flows of financial securities and period end balance sheets of households, businesses, investors and governments.

Why it's important, but not market moving. The downside of the flow of funds report is that by the time it's published the analysis is very backward-looking. Thursday's report will update the data through 3Q 2014. The Treasury information in particular is reconstructed in part from the TICs data, so much of that information has already been made available*. Therefore any market moves that were driven over a quarter by changes in flows of, say, Treasuries, agencies, or corporate securities by a particular financial group - e.g. banks, pension funds, foreign central banks - have already taken place. Also, the data doesn't give a maturity bucketing breakdown of security buying or holdings by different investors - though it does in many cases separate Treasury bills from other Treasury securities - so the flow information it provides is "big picture".

*Sidebar: There are known and long-standing issues with the TICs data, which we won't rehash here. Government analysts have worked tirelessly over the years to improve the quality of the data, make the collection of it more timely and the data itself less subject to revision. This has in fact made the data much more relevant and useful. Despite those efforts, global reporting requirements of financial holdings are, to a great extent, voluntary. There is no system that currently exists where you can enter the cusip of a security and pull up a list of beneficial owners and how much par value they hold. "Yeah, but, the Treasury has to send payments to the bondholders, so they must be able to track who owns them." They can track the settlement details of security transactions, and the processing of the coupon or principal payments - but that tracks to the bank where the security is held, not to the owner of the account. So if the banks in Belgium hold $500 billion of Treasury securities in accounts for individuals, corporations and/or government entities all over the world, that $500 billion securities will still appear to be beneficially attributed to the country of Belgium in the TICs data because that is where the payments go. There is not (or not yet, anyway) comprehensive regulation - in the US or globally - that requires banks to turn over individual account information to the government. Of this you should be thankful.

Disclaimer to the sidebar: The above is based on my understanding of the Fedwire and Treasury payments processing systems. My understanding may be faulty or outdated, so please improve it and/or correct any mistakes, especially if you work for the Fed, the Treasury, or the FBI. (If you work for the IRS, just leave it.)

But it is useful for trend analysis and making projections. Despite the drawbacks, for our purposes the data is useful for analyzing broad financial market flows and investment trends. And one trend for at least the past decade has been that the rest of the world is the dominant financing partner of the US government. The chart below shows the amount of Treasury securities held by sector (in $ billions).

"Monetary authority" in the graph above refers to the Federal Reserve bank. Together, the US central bank and the "rest of the world" - which in the case is overwhelmingly foreign central banks - are now holding almost two-thirds of US government debt.

If we look at the quarterly flows (see the chart below), we see the same thing: that the rest of the world has most often been the dominant net buyer, while US investors - particularly households - have frequently been the dominant net sellers of Treasury securities.

Note that the quarterly flows above are seasonally adjusted annualized rates - which crudely means you need to divide by four to get the actual flows. I are a mathematician.

So what do we know. The Fed started tapering their Treasury purchases - you see that in the flows over the past two quarters as the blue bar gets smaller. Thursday's data should show Fed flows in Treasuries of zero in 3Q 2014. My guess is that you will see an increase in "rest of the world" buying, as the global economy slowed down and the dollar appreciated strongly against most other currencies in the 3Q (and continues to do so).

If I were going to make an argument for rates staying stubbornly low next year despite the Fed hiking, this is where I would start. As long as the major global economies are weak while the US is improving, there will be an overwhelmingly strong bid for Treasuries from the rest of the world.

Instead of making that argument - because you've all been inundated with "2015 Outlooks" from every sell-side and buy-side analyst on the street (and don't lie to me, I know you only read the bullet points) - what I plan to do is spend some time learning more about currencies, interest rate parity (which is apparently a great theory that seems to never actually work) and cross-asset correlations. Oh, and I will briefly update these charts on Thursday after the actual flow of funds report comes out.

Bravo to the Fed: the Repo Test is Working

Background: The previous post, Litmus Test for Monetary Policy Started Monday, reviews the rationale of the Fed's ongoing test of "just barely" raising the reverse repo program (RRP) rate to assess the impact on the front end of the curve.

Success: Other short term rates have risen in tandem this week with the Fed's upward pressure on RRP from 7 to 10 bp (see chart below). The Fed effective has notched from 9 bp to 12 bp; the general collateral Treasury repo rate has stayed elevated at ~20 bp; and perhaps most importantly, AA financial, non-financial and asset backed commercial paper rates have edged up from 3 to 7 bp to 9 to 12 bp (not shown on chart, data available here). This provides modest but important confidence that - when the Fed does begin to tighten policy sometime next year - raising the RRP rate will likely function as an effective transmission mechanism to other short-term secured and unsecured lending rates.

Volatility in the Fed effective still likely but tolerable: One thing the Fed has not done is push the RRP rate high enough to fully induce the lowest bid cash lenders (some of the FHLBanks) to move all of their lending away from the Fed funds market. You can see in the second chart above the intraday high and low bids (the gray and orange lines) plotted with the Fed effective, which is the volume weighted average rate. The only way that the daily average can be that low - that close to the lower bound - is if the distribution is highly skewed towards the lowest lending rates. The worry - or eventual expectation, really - is that if the FHLBs were to significantly or completely reduce lending in the Fed funds market in favor of RRP or CP or another higher, short-term market, then it would push the Fed effective to set materially higher towards the intraday high of ~31 bp. That's actually not a big deal in reality, as the number of institutions that borrow in the intrabank market is very low, and functionally it changes nothing to have the fed effective rate reset without the presence of the FHLBs. Optically it would of course be shocking to those who don't follow this market closely (that is, practically everyone) but after a period of volatility, the Fed could no doubt convince the market to maintain its focus on the RRP and the interest on excess reserves (IOER) rates as opposed to the Fed effective.

Next steps - determining the spread between RRP and IOER: The Fed is maintaining the RRP rate at 10 bp through the end of next week, then is expected to drop it back down to 5 bp. I suspect the Fed will arrange another test early next year where it raises the RRP rate to 15 or 17 bp for a short period of time. This would give the Fed some information - to back up a lot of untested theory and educated modeling (guessing) by Fed researchers - of what may be a "normal," maintainable spread of RRP to IOER. Although it can seem pedantic, setting a “normal” spread between the two rates is more than an academic exercise. The RRP rate is a collateralized lending rate where – at least for now – mostly money market funds lend money to the Fed on a secured basis in exchange for Treasuries. This is the shadow banking system lending to the safest counterparty on the planet. The IOER rate is the Fed paying interest on cash reserves in the banking system - which it created through 3+ rounds of quantitative easing - to the depository institutions that hold those reserves. The Fed needs the secured lending rate in the shadow banking system to influence, but not be pari passu with, the unsecured interest / lending rate in the banking system. And for both of these avenues to effectively transmit the tightening policy throughout the market.

Guesses are that the two rates should be held anywhere from 5 to 20 bp apart. With the IOER currently at 25 bp, and it becoming the de facto "fed target rate" through the next tightening cycle, that would mean the Fed would set the RRP rate anywhere from 5 bp - where it is currently - to as high as 20 bp, as a lower bound before the FOMC begins to tighten monetary policy.

What could go wrong? The answer that almost everyone will give you is that inflation could ignite since the Fed will eventually be trying to tighten policy without draining the $2.7 trillion of extra liquidity in the banking system. The Fed will tell you that they can successfully tame any unwanted inflation by raising IOER rapidly, which discourages banks from lending money / providing easy credit at rates below where they can safely earn interest on those reserves. All of that is true, but not what worries me.

The Fed’s reverse repo program has now grown to about $150 bn in size. That is, each day the Fed takes in roughly $150 bn of cash from various lenders, predominantly money market funds, in exchange for $150 bn of Treasury collateral. At current operating size the RRP is now larger in total par value than the general collateral Treasury repo market as cleared each day at the Fixed Income Clearing Corporation (FICC) (chart above).  The Fed has recently capped the size of the RRP operations to $300 bn. Given the path the Fed has chosen, this was probably an inevitable necessary step, but it is contrary to their stated role of being the “lender of last resort”. Instead of influencing short-term rates, the Fed has now inserted itself as a major participant and provider of collateral into the short-term markets. Eventually there will be another financial crisis. Hopefully it will occur long after the Fed has stepped back from these large-scale operations, allowing them to successfully intervene as necessary and function in the role of liquidity backstop and not “liquidity market maker”. 

Litmus Test for Monetary Policy Started Monday

What if the Fed raised rates and the market didn't respond? Today through year-end is when the Fed and the market will get its first inkling of whether or not the Fed can successfully pressure short-term rates higher without draining $2.7 trillion of excess reserves in the banking system. This is a big deal. This is the first real test of whether or not raising the reverse repo program (RRP) rate will potentially be an effective conduit of monetary policy.

The test. As of Monday, the Fed raised the overnight reverse repo rate to 10 bp, and will leave it there through mid-December. That means the Fed is willing to pay interest of 10 bps to investors of cash, and provide Treasury collateral in exchange to secure the overnight loan. These cash investors are predominantly money market funds, most GSEs and large institutional asset managers. The cap on the overnight RRP is $300 billion. Additionally, the term reverse repo program will run four operations in December that will span year-end, with a cap of $300 billion and a maximum bid rate of 10 bp. This is the highest rate that the overnight and term program have offered for RRP cash investors. Importantly, the 10 bp rate for secured cash investments with the Fed is above current unsecured fed effective (9 bp), overnight Libor (9 bp) and AA commercial paper rates (3 to 9 bp out to 30 days).

The propagation of monetary policy. For the Fed's new monetary policy target to be effective, it will need to pressure rates higher across the short-term spectrum. The counter-parties actively participating in the Fed's RRP have been so far heavily weighted towards money market funds. The transmission mechanism for tightening credit will need to transmit from these institutional lenders of secured credit in the so-called "shadow banking system" to the secured and unsecured inter-bank and non-financial markets - tri-party repo, fed funds, commercial paper, Libor, CDs.

"I thought the Fed hated the shadow banking system." That's what's called irony. It is now dependent upon that system - and the banking system to some extent as it raises IOER - to transmit its monetary policy throughout the short-term rates complex.

Why has the Fed shifted its monetary policy target from Fed funds to IOER and reverse repo? Cursory outline in bullet points. Don't expect any nuance.

• For years, if not decades, prior to the financial crisis, "excess reserves" - or extra cash/liquidity in the banking system above the reserve requirements - used to average $20 to $40 billion per day. 
• Required reserves are roughly analogous to a minimum daily balance required for a checking account. Most depository institutions in the US have a "checking account" with a Federal Reserve bank, where they are required to maintain a minimum reserve cash balance based on things like the total amount of their daily transaction volume, size of their depository base and so on. 
• Prior to the financial crisis, if a bank exceeded the daily reserve requirement in its account, it had "excess reserves." Unfortunately, this excess cash received no interest. 
• The excess reserves can be loaned overnight from one bank to another to meet the Fed's reserve requirements. Reserve requirements are no joke: "Thou shalt not bounce a check to the Fed." Banks that had extra cash would loan it overnight to another bank to earn interest, instead of leaving it in their own account earning nothing.
• The market for these interbank loans of reserves is known as the Federal funds market, and the average interest rate at which the loans take place is known as the Fed funds effective rate. 
• The Fed used to primarily conduct monetary policy by setting a target Fed funds rate, and either increasing or decreasing the amount of reserves in the banking system to keep the Fed effective close to the target rate.
• A direct result of the Fed's quantitative easing programs is that $2.7 trillion of excess reserves / cash / samolians / clams are now floating around in the banking system. Most banks have no need to borrow reserves. 
• Furthermore, the Fed began paying interest on excess reserves (IOER) equal to the target Fed funds rate - currently 25 bp - so no bank with excess reserves has an incentive to loan them out for less than that rate. 
• The amount of lending in the Fed funds market plummeted from ~$100 to $200 billion per day (that's a best estimate) pre-crisis, to as low as $20 to $30 billion per day. Moreover, the vast majority of the lending is no longer bank to bank, but government agency (GSE) to bank, because GSEs cannot earn IOER since they are not depository institutions. 
• Instead of trying to drain the (ocean with a teaspoon) excess liquidity out of the financial system in order to raise the fed funds rate, the Fed has begun targeting other non-bank specific short-term lending rates as a target when it begins to tighten monetary policy. 
• The rates the Fed is now targeting for conduction of monetary policy are the interest on excess reserves rate (IOER) and the lending rate for the reverse repo program (RRP). 

Is this going to work? We all better hope so. Last week the Fed raised the RRP rate to 7 bp and there was a decent response from the fed effective and repo. This is a somewhat bigger test, as it should have some impact on the CP markets, even if its small. The problem with money market funds and shadow banking in general is its very bucketed in what it can and cant invest in for risk purposes. Once it fills the "repo" bucket, the funds may be forced to lend money cheaper elsewhere, simply to avoid exceeding proscribed risk limits (that were, ha ha, often the result of new Fed and SEC regulations). So the transmission may only go so far. We will get some information and report back soon.

The Term Premium: the Economics Version of the Flux Capacitor

This is the economy in recovery: US 3Q GDP printed this morning at 3.9%, up from the advance estimate of 3.5%, and well above the consensus forecast of 3.3%. Although some portion of 2Q GDP of 4.6% was clearly due to a weather-related bounce back from the -2.1% of 1Q, it now seems obvious to perhaps all but the most stubborn bears that the US economy has been on a strengthening economic trajectory since at least the middle of 2013. 

The so-called conundrum? Long-term US Treasury yields continue to decline. In 2013 as the economy began to show signs of persistent strength and the Fed indicated it was finally preparing to end QE, 10y Treasuries sold off by ~120 bp, yields touched just over 3.00% in January 2014, and the yield curve steepened. Instead of long rates "following through" on that momentum as the economic recovery gained steam - as most* financial analysts expected (myself included) at the beginning of 2014 - long rates have reversed course and steadily rallied throughout the year, and the yield curve has flattened. Why? for the love of corn muffins, why?

*Jim Vogel and Chris Low of FTN Financial were one of the few, if not only, high profile strategists to predict that the 10y Treasury yield would fall substantially in 2014. Huge kudos to them for getting the direction right, particularly against an intensely tight consensus the other way. I don't have access to their research so I don't know what reasons they gave for the call, but unless they were projecting that rates would fall due to a renewed recession and QE4, that's just darn impressive. 

The level of interest rates, the shape of the yield curve and the business cycle. As all students of finance and economics know, interest rates tend to rise and the yield curve tends to flatten as the economy improves, inflation rises and the business cycle peaks. Conversely, interest rates tend to fall and the curve steepens again as economic strength declines and the business cycle heads to a trough. The primary driver of the flattening and steepening has traditionally been the Fed's conduction of monetary policy: with the Fed changing the level of short-term interest rates while long-term rates adjust to economic and market conditions. In normal business cycles, the Fed raises short-term interest rates - to prevent the economy overheating and inflation from rising too fast - through the peak of the cycle, which typically results in a flattening of the yield curve. Eventually the Fed lowers short-term rates - which effectively steepens the yield curve - to ease credit conditions as the economy weakens, in order to prevent or numb a recession. 

Short-term rates are pricing in a tightening cycle... The Fed has yet to raise short-term interest rates, but the front end of the yield curve has modestly sold off in anticipation. Interest rate futures contracts also show that the market is pricing in eventual rate hikes, beginning roughly in the middle of 2015. 

...Amidst a secular decline in long-term interest rates. For more than 20 years, these cyclical variations in interest rates and re-shapings of the yield curve have been taking place within the context of a secular decline in long-term yields. From What Caused the Decline in Long-term Yields? by San Francisco Fed economists Bauer and Rudebusch, July 2013 (edited for brevity):

During the past year, yields on long-term U.S. Treasury securities have fallen to historically low levels. ... These low yields partly reflect cyclical factors, including the slow pace of economic recovery, modest inflation rates, and accommodative monetary policy. However, in addition to cyclical variation, yields have registered a longer-run decline. Indeed, from 1990 to 2012, 10-year U.S. Treasury yields fell fairly steadily from just over 8% to around 2%.

Identifying the sources of this long-run decline in interest rates is of great interest to monetary policymakers, bond investors, and other financial market participants. But it is quite difficult to do. 

Many economists have attributed much, or in some cases most, of the secular decline in long term rates to a collapse in the term premium. Also, one way that the Fed purported to measure the effectiveness of QE was by estimating how much of the cumulative drop in yields over the various purchase programs was due to compression of the term premium.

The term what? I hear you. I will try to make this as simple as possible, but honestly it's such a convoluted concept - and subject to almost comically wide variation in estimation methods - that at times it's difficult for me to take it seriously (shhh...don't tell any economists). 

Defining the term premium. Let's return to Bauer and Rudebusch (edited slightly for clarity, formatting added):

Long-term interest rates can be separated into two components: expectations of average future short-term interest rates and a term or risk premium that investors require for bearing the risk of a long-term bond investment.

• The expectations component is driven by inflation expectations and expectations of future real rates of return, which depend on future economic growth.

• The risk or term premium component is determined by the amount of uncertainty about these future developments and by the degree to which investors are risk- averse and require compensation for a given amount of variability.

These two components of interest rates are not readily observed and must be inferred indirectly. The usual method involves the estimation of a dynamic term structure model, a statistical model that describes the interaction of short-term and long-term interest rates and their evolution over time. With estimates from such a model, a researcher has the necessary tools to identify the expectations and risk premium components of interest rates.

Editor's aside: May I just point out that there is no mention of supply and demand anywhere when estimating long term rates? So if, say, China were to enter the market and buy a few hundred billion of Treasury securities in order to deflate their currency, and that were to have a meaningful impact on long term rates, these models would instead be trying to account for that as perhaps a change in either inflation expectations or a change in risk aversion? I strongly suspect this is a limit in my own understanding, not necessarily in the definitions or models.

Economics is not physics. There is a body of very sophisticated, statistical finance literature that is dedicated to estimating changes in the term premia of interest rates, most often the 10-year Treasury rate. This research is done by people who are exceptionally serious, talented and dedicated. The problem is that there are no fundamental laws of economics. 

There are at least five different classes of econometric models that have been used to produce term premium estimates, with at least four producing estimates going back to 1961. There is a wonderful chart of these term premium estimates over time, and more detailed explanation of the various models, available on Simon Taylor's blog  here. 

He provides an outstanding high level overview and I strongly recommend you read his work. The synopsis is that by 2007, four of these models estimated widely divergent term premium  from -2.00% to +2.00% when the yield on the 10yT was ~5.00% . 

The Fed - either in its infinite wisdom or infinite hedging - chooses to use a term premium model that produces estimates roughly in the middle of the range of the other four. To my knowledge - and I could be wrong - modeling and estimating the term premium has not become less controversial or more robust over time, and I don't know that the variation in the estimates has meaningfully decreased. In my opinion that tends to undermine the practicality of using the term premium to explain a significant fluctuation in long term interest rates, or assigning any importance to a projection made based on a change in the estimate of the term premium. 

Fed Effective Twitches Higher as Fed Increases Rev Repo Rate

Refresher: The Fed's reverse repo program is a secured lending program. That means that the Fed borrows money from counterparties - primarily money market funds, banks and the GSEs - and the Fed lends (collateralizes the loan) with Treasury securities. This drains cash from the financial system for the term of the loan (overnight). Another way to think of this is that money market funds, banks and the GSEs normally have large piles of cash. That cash can either sit on their balance sheet earning nothing, or they can invest it. One option for investing it overnight is at the Fed - fully collateralized in exchange for Treasuries - and earn the reverse repo rate set by the Fed, which for most of the past year has been 5 bp. Which beats investing in similar maturity T-bills and has less credit risk than, say, unsecured overnight commercial paper.

Victory for the Fed! The open market operations group at the NY Fed must be high fiving each other right about now. And deservedly so. As previously announced, they raised the rate for the Fed's reverse repo program (RRP) from 3 to 7 basis points this week - a new high for the program since its inception in September of last year - and the Fed effective (the average daily Fed funds rate) rose right along with it, from 9 to 11 bp. Not surprisingly, the higher RRP rate attracted more bidders for the Treasury collateral - with yesterday's bids rising to $167 bn from last week's average of $100 bn per day.

Sidebar: The drop from 5 bp to 3 bp  last week was also a "test drop". Just ignore it and assume the previous rate was 5 bp where it had been held since early in 2014.

Next raise coming in December. The Fed will keep the RRP rate at 7 bp through the end of this month, then raise it again to 10 bp for the first two weeks of December. That should push the Fed effective up to 14 bp and increase the "intraday low" bid for Fed funds (shown on the graph in orange) to 10 bp, which has so far followed the RRP rate almost in lock-step.

What's the point of all this? The Fed is trying to establish whether or not the rate offered in the RRP can function as a lower bound for other short term rates - in particular the Fed funds rate - when it begins to raise rates sometime next year. The Fed became sharply aware post-crisis that the Fed funds market is thin and dominated by non-bank lenders. The Fed effective needs to have a new, more reliable fixing process (which is being discussed) or the Fed needs to migrate away from using it as their benchmark rate of monetary policy (also being discussed, though the FOMC is not quite admitting to that now).

Impact on other lending rates. Treasury general collateral repo rates outside the RPP have been pushed higher of late, so they did not clearly rise from the Fed's increase to 7 bp, but it will be interesting to see if they do follow suit higher in December.

 

Economic Consequences of Immigration Reform at Best Mixed; Amnesty Highly Negative

The “in way over my head” disclaimer: My original goal was to understand if there should be any financial market repercussions from political action on immigration. This was clearly a ridiculous undertaking for an issue of this complexity. I spent the better part of a week reading research papers, reviewing immigration data, trying to understand how the economic models result in, at times, widely disparate projections of the potential economic and fiscal impact of immigration.

Luckily there is some excellent research from several highly regarded  U.S. and international sources which broadly agree on the consequences of immigration, though their economic impact estimates vary due to the sensitivity to underlying assumptions. What follows is my best attempt to distill fact and reasonable projection from misleading headlines regarding the fiscal impact analysis of:

1. Recent legislation that would enact comprehensive immigration reform (Senate bill S.744); and 
2.  Executive action which would potentially grant amnesty to some large subset of unauthorized immigrants.

All mistakes and misunderstandings are entirely my own, and not the fault of the source materials (which are cited extensively, as they are the experts, not myself).

Ignore the extremes: Like most political issues in the US, the fringe views are polarizing. The “social debate” over immigration is bracketed on the far right by barely disguised xenophobia – often with a palpable undercurrent of a particularly hostile brand of religious fundamentalism; and on the left by a My Little Pony fantasy of progressive liberalism, where diversity and inclusion naturally leads to peace, harmony and economic prosperity for all (see: people who have not read Animal Farm).  

Immigrants are us: The following facts are culled directly from A Description of the Immigrant Population - 2013 Update by the Congressional Budget Office (formatting added, edited for brevity). 

• The resident U.S. population in 2011 was about 312 million.
• In 2012, about 40 million foreign-born people lived in the U.S., making up about 13% of the U.S. population – the largest share since 1920. 
• Naturalized citizens (foreign-born people who have fulfilled the requirements for citizenship) accounted for about 18 million.
•  Non-citizens accounted for about 22 million.
• Of these 22 million non-citizens, about half (11.5 million) were people without authorization to live or work in the U.S., either temporarily or permanently.
• This is 3 million more illegal immigrants than in 2000.
• Of non-citizens unauthorized to live in the U.S., an estimated 59% (6.5 million) were from Mexico, and 14% (1.5 million) were from El Salvador, Guatemala or Honduras.
• The foreign-born population tends to be less educated than the native-born population. In 2012, 27% of the foreign-born population between the ages of 25 and 64 had not completed high school, compared with 7% of the native-born population. 
• That difference was even larger among foreign-born people from certain regions of the world. A majority of people from Mexico and Central America, for example, had less than a high school diploma. However, foreign-born people from Asia, Canada and Europe, and Africa and Oceania are more likely than their native-born counterparts to have a bachelor’s degree or more.

Immigration economics in a nutshell: There is loud, and at times deliberately misleading, clamoring that (a) immigration increases economic growth; and (b) it is therefore a net benefit to the country. All serious research and analysis supports part (a); unfortunately that in no way implies the conclusion in (b). In fact, the net economic impact on the native born population can be heavily negative and a fiscal drain to the country, primarily depending on the composition of the immigrant population.

This seeming contradiction is well summarized in research from the Dallas Federal Reserve, in its paper Immigrants in the U.S. Labor Market , September 2013; excerpts below (formatting added, edited for brevity):

The United States is the world’s top destination for migrants. It is home to 19 percent of the world’s migrants and between 40 and 50 percent of the world’s unauthorized migrants. No other nation takes in as many immigrants. On the benefits side, immigration boosts the U.S. economy, enhances productivity, spurs innovation, helps consumers by keeping prices low, and enriches U.S. society and culture. On the costs side, there are at least two important caveats to consider. 

• Immigrants to the U.S. are disproportionately low-skilled and, hence, low-wage. Low-wage immigrant households have an adverse fiscal impact, receiving more in public services than they pay in taxes, on average.
• The economic gains from immigration are not distributed equally among natives. Competing low-skilled workers, for example, may suffer wage losses, and poor households will not benefit as much as rich ones from lower prices for immigrant-produced goods and services since they consume less of those products.

The positive economic impact is greatest for high-skilled and employment-based migration, particularly of science, technology, engineering and math (STEM) workers, who can directly influence innovation and, hence, productivity growth. 

However, U.S. policy allocates only a small fraction of permanent resident visas to employment-based immigrants, who are overwhelmingly high-skilled, reserving most so-called “green cards” for family and humanitarian cases—people who frequently have much less education than employment-based immigrants. In other words, quotas restrict the most economically-beneficial immigration by awarding permanent residence primarily on the basis of family ties. 

The large number of unauthorized immigrants and the shortage of high-skilled visas, along with a host of other issues, have prompted calls for comprehensive immigration reform.

What is the “reform” in immigration reform? Immigration reform is in some respects like tax reform. Congress is attempting to update an archaic system that has been patch-worked with special interest duct tape and line item silly putty until it has nearly collapsed from the weight of complexity and post-9/11 obsolescence. Drastic overhauls of immigration law are routinely proposed by Congress and either die in committee or are ignored by the opposing chamber. From Congressional Research Service report of February 2013, a Brief History of Comprehensive Immigration Reform Efforts (formatting added, edited for brevity):

The Immigration and Nationality Act (INA), which was first codified in 1952, contained the provisions detailing the requirements for admission (permanent and temporary) of foreign nationals, grounds for exclusion and removal of foreign nationals, document and entry-exit controls for U.S. citizens and foreign nationals, and eligibility rules for naturalization of foreign nationals. Congress has significantly amended the INA several times since 1952, most notably by the Immigration Amendments of 1965, the Refugee Act of 1980, the Immigration Reform and Control Act of 1986, the Immigration Act of 1990, and the Illegal Immigration Reform and Immigrant Responsibility Act of 1996.

During the 109th Congress, both chambers passed major overhauls of immigration law but did not reach agreement on a comprehensive reform package. Leaders in both chambers of Congress have listed immigration reform as a legislative priority in the 113th Congress. Most policymakers agree that the main issues in “comprehensive immigration reform” (CIR) include, 

• increased border security and immigration enforcement, 
• improved employment eligibility verification, 
• revision of legal immigration (this generally includes expansion of permanent legal immigration, also supported George Bush), and 
• options to address the millions of unauthorized aliens residing in the country.

Then—as well as now—the thorniest of these issues centered on unauthorized alien residents of the United States.

The latest version of immigration legislation is contained in the bill S. 744 The Border Security, Economic Opportunity and Immigration Modernization Act, which was passed by the Senate on June 27, 2013. President Obama has urged  the House to vote on it “or else.” The “or else” being that the White House is now preparing to use executive power to possibly grant amnesty and/or slow down deportation proceedings for some large subset of unauthorized alien residents.

The economic impact of S.744. The federal fiscal projections of any new legislation are, as always, done by the usually reliable and staunchly non-partisan Congressional Budget Office (CBO). The complete report can be found here. The incredibly brief summary is as follows:

• The CBO estimates that enacting S 744 would lead to a net increase of 9.6 million people over current projections by 2023. 
• Federal revenues would be higher due to the increased size of the labor force, as would the costs of federal benefit programs, direct spending for enforcement and other discretionary spending relative to immigration activities. 
• On a net basis the CBO projects that the federal budget deficits would shrink by about $158 billion over the 2014-2023 period from enacting S.744.

Well, that’s great, right? Immigration reform is projected to shrink the federal deficit over 10 years. Given that federal deficits are running at $500 billion a year and projected to climb towards $700 billion per year by 2023, or roughly $6 trillion over the 10-year period, that $158 billion is a drop in the proverbial bucket. But hey, at least immigration reform is not a net negative. Not quite so fast.

The issue is that the CBO is mandated only to consider the fiscal effects on federal revenues and spending. Much of the cost of low-skilled immigrants, both legal and illegal, are born by state and local governments. Back to the research from the Dallas Fed:

High-skilled immigrants, generally well educated with substantial incomes, pay more in taxes than they consume in publicly-provided services. By comparison, low-skilled immigrants are a net fiscal drain because of their low wages, large families and lack of employer-provided health insurance coverage. In 2010, about 31 percent of immigrant-headed U.S. households participated in a major means-tested public assistance program, compared with 19 percent of native-headed households.

It is important to note that higher welfare participation among immigrants in the U.S. is

not related to lower employment among low-education, foreign-born household heads (which is often the case in other advanced economies). In the U.S., low-education immigrants actually have much higher labor force participation rates than similar natives. Rather, the difference is due to greater immigrant participation in public health insurance programs, such as Medicaid and CHIP (the Children’s Health Insurance Program).

With regard to unauthorized immigrants, most attempts to calculate their net fiscal impact

conclude that they also pay less in taxes than they receive in services, on average. Like low-education legal immigrants or low-education natives, they receive more in government benefits than they pay in taxes, on average. However, since they are not eligible for most welfare programs, illegal immigrants have a smaller adverse fiscal impact than low-wage legal immigrants. In both cases, the fiscal burden is particularly heavy for state and local governments, which bear a large share of costs for schools and health care.

There are several studies which incorporate the total federal, state and local government costs for low-skilled immigration. Suffice it to say these estimates vary widely but are uniformly negative, and the cost of such immigration can only be offset by including large proportions of high-skilled immigrants. Significantly larger proportions of high-skilled immigrants than what the U.S. admits now.

The economic effects of an amnesty for unauthorized workers. I’m getting tired and this is way too long already, so I’ll keep this brief since I’m sure the outcome is already obvious. Studies project that granting widespread amnesty to unauthorized immigrants – who we already know are predominantly low-skilled with a roughly 10^th grade education – would probably produce a brief positive impact in revenues as income and payroll tax collections increased.

Unfortunately over the longer term this likely turns negative – perhaps profoundly negative - as benefit rolls and the cost of services increased. Legal immigrants qualify for many more benefit programs than illegal immigrants.

There’s also a second problem with amnesty that we’ve already experienced – it produces a tidal wave of new, unauthorized immigration. There was a large-scale amnesty program included in the 1986 IRCA immigration reform bill. Conclusions from an INS report in 2000: 

• Amnesties clearly do not solve the problem of illegal immigration. About 2.7 million people received lawful permanent residence ("green cards") in the late 1980s and early 1990s as a result of the amnesties contained in the Immigration Reform and Control Act (IRCA) of 1986. But these new INS figures show that by the beginning of 1997 those former illegal aliens had been entirely replaced by new illegal aliens, and that the unauthorized population again stood at more than 5 million, just as before the amnesty.

• In fact, the new INS estimates show that the 1986 amnesty almost certainly increased illegal immigration, as the relatives of newly legalized illegals came to the United States to join their family members. The flow of illegals grew dramatically during the years of the amnesty to more than 800,000 a year, before dropping back down to around 500,000 a year.

The irony of granting amnesty is that it’s hardest on the native born population that competes with immigrants for jobs – the young, low-skilled and poorly educated. Most of the gains are transferred to the immigrants as higher wages at the expense of consumers and these other groups. 

Closing remarks. Comprehensive immigration reform is certainly needed and long overdue. Done correctly – and I will leave it to the experts to argue particulars - but a bi-partisan bill like S.744 is probably worth a vote in the House (looking at you, Boehner). Amnesty is not a solution. Not for low-income Americans who will pay the highest price, not for high immigrant states that will bear an outsized fiscal burden. My opinion only, as always. 

With the Global Economy on its Knees, Regulators Seek Even Higher Bank Capital Requirements

A case of regulatory excess. Despite the thousands of pages of Dodd-Frank and Basel III that have resulted in an extensive new network of financial regulation and regulatory bodies (hello FSOC, CFPB, et al) since the crisis, global regulators are still not satisfied. Or perhaps like fading Hollywood celebrities, they feel their relevance slipping away as the global economies have bogged down and the financial markets have become rather tedious.

A recent Wall Street Journal article, World's Largest Banks to Be Forced to Hold Big Capital Cushions, reports that a new regulatory capital requirement for global systemically important banks (G-SIBs) has been proposed by the Financial Stability Board (FSB):

The world’s largest banks will have to hold 16% to 20% of their risk-weighted assets in equity and cancelable debt to shield taxpayers from big bills for bailing out failed banks during a crisis, according to a plan by global regulators published Monday.

Regulators see this rule as a way to put an end to the so-called “too-big-to-fail” problem—a crucial step in preventing bailouts for large lenders and shielding taxpayers from having to foot the bill for failing banks.

A few points, then we’ll move on to discussing bank capital:

1. I’m all for addressing the “unfinished business” of the financial crisis. Pretty much everyone realizes that both the regulatory response during the crisis, coupled with the expansive (and at times scattershot) post-crisis regulation, has done more to cement the idea of “too big to fail” than it has to abolish it. So ok, I get what they’re trying to do. But...
2.  Really? A seventh new (or higher) capital (or liquidity or collateral) ratio for banks to satisfy that will continue to put downward pressure on bank lending and wages GLOBALLY? Higher capital requirements are already being phased in, thanks to Basel III, and that’s not the only tool in the toolshed, right? If you want to make those capital requirements more meaningful, try standardizing the financial accounting rules first, so at least we don’t start by comparing apples to grapefruits.
3. For the last time, in the US the “financial bailout of the banks” did not cost the taxpayers one dollar. Of the roughly $250 billion of capital (nee taxpayer funds / TARP money) that was injected into the banks, over $280 billion in total was repaid (capital plus interest) within 5 years (and the bulk of it was repaid within 3 years). The US taxpayers made a profit of $30 billion on the “bank bailout”.

Ok, I’m done. Sort of. Here are the facts, with plenty of reference material linked.

What’s the FSB? The FSB was established in 2009 as a successor to the Financial Stability Forum. The FSB draws its membership from international finance ministries, supervisory agencies and central bankers from the G-20 countries. The purpose of the FSB is to assume a key role in promoting the reform of international finance regulation and global financial stability.The FSB – like the Bank for International Settlements (BIS) and its Basel Committee – lacks the authority to impose its recommended financial rules and standards, as there is no such global banking regulator (laws being mostly national, and all that). Instead, the FSB relies on the influence of their global members to incorporate their proposed rules into the financial regulatory framework in each country. Before you breathe a big sigh of relief (or high-five your buddy at the FDIC), the current head of the FSB is Mark Carney, also the governor of the Bank of England. The FSB certainly does not lack for influence over the regulatory policies of the G-20 nations.

The role of bank capital. The following is quoted from an excellent Primer on Bank Capital authored by Douglas Elliott of the Brookings Institution (formatting added, edited for brevity).

In its simplest form, capital represents the portion of a bank’s assets which have no associated contractual commitment for repayment. It is, therefore, available as a cushion in case the value of the bank’s assets declines or its liabilities rise.

Capital is intended to protect certain parties from losses, including depositors, bank customers, and bank counterparties. ... Common stock is the purest form of capital because there is no requirement to ever pay it back, nor is there a legal requirement to pay dividends. Common stock also has the lowest payment priority in bankruptcy, with the legal right only to receive any residual value after all other claimants are paid.

Bank capital requirements. Regulatory and ratings agencies both set a variety of capital requirements for banks. These capital requirements are usually expressed as a ratio of some definition of capital to assets:

                Capital* / Risk-weighted assets          or            Capital* / Total assets

where Capital* can be Tier 1 capital, Tier 2 capital, Total capital or – the newly proposed FSB capital classification – Total Loss Absorbing Capital (TLAC) which would be appear to be equity broadly defined plus cancelable debt (maybe that includes contingent capital? The standards are still in flux).  

For example, beginning in 2015 most banks minimum Tier 1 capital ratio has to exceed 6%. This is the ratio of Tier 1 Capital to risk-weighted assets. Tier 1 capital is the strictest definition of capital used by  regulators, and includes only common equity (paid-in capital and retained earnings) and non-cumulative perpetual preferred stock. As the definition of allowed capital expands, the required ratio of capital to assets increases.

More capital equals safer banks, and a safer banking system. When the financial crisis hit and banks, brokerages and other financial companies were struggling and failing left and right, most people agreed that (1) bank capital was too low, and (2) bank leverage was too high. (There is an important point to be made that neither Lehman or Bear failed due to lack of capital, but most of you are well aware of those circumstances so I’ll skip the obvious argument of regulatory overreach.)

Anyway. Financial regulators – adopting measures proposed in Basel III - increased a variety of bank capital requirements and introduced several new ones (e.g. the leverage coverage ratio, the liquidity coverage ratio) in the wake of the financial crisis to make the banking system safer. The phasing-in of increases in Tier1, Total Capital and the Capital Conservation Buffer are shown in a chart (slide 13 of 15) in from a great presentation by Emily Yang of the Federal Reserve bank of New York called Bank Capital and Regulation. )I tried to copy the image from pdf into my blog, but apparently I still a blog technology nitwit. Will try to update soon.)

The cost of capital varies by country and across the business cycle. The downside is that capital is very expensive for banks. Research from Michael R King, The cost of equity for global banks: a CAPM perspective from 1990 to 2009 published in the BIS Quarterly Review, September 2009:

One lesson drawn from the ongoing financial crisis is that banks should hold more common equity in their capital structure. Common equity is the first category of bank capital available to absorb losses; the greater this cushion, the more losses a bank can withstand while remaining financially viable. For this reason, common equity is also the most expensive form of bank capital, as investors expect to be rewarded for the greater risk they bear through some combination of dividends and capital appreciation.

Higher capital standards increase the operating costs of the bank, driving the cost of lending higher, compensation lower, and ultimately being a drag on economic growth. Below I briefly recap extensive research and commentary from the BIS, the aforementioned Douglas Elliott, and from the FSB itself on the potential impact of higher capital requirements.

Based on research from the BIS (paper cited above), the cost of equity to the bank varies by country and across the business cycle. King compares the cost of bank equity across six different countries and over time. King shows that the average cost of equity for banks in the 2002-2009 period varied from a low of 5.4% in Canada to a high of 11.2% in Japan. Furthermore the cost of equity decreased steadily in most countries except for Japan from 1990 to 2005 as real risk-free interest rates declined. Given that the cost of equity capital for banks is

(a) not equal across countries or among institutions within a single country;

(b) sensitive to the stage of the business cycle; and

(c) varies with real interest rates in a country,

it seems unpredictable at best to impose a “global standard” capital charge on banks.

The trade-off between bank safety and economic growth. Perhaps the bigger issue is that the potential impact of raising bank capital standards (again) is the chill it puts on bank lending, employee wages in the sector, and economic growth. From Douglas Elliott’s primer on bank capital (edited for brevity):

Higher bank capital requirements are likely to result in higher interest rates on loans, lower rates on deposits, and reduced lending. Higher capital levels increase the total expense of operating a bank and making loans, even taking account of the decrease in the cost of each dollar of bank equity and debt due to the greater safety of a bank which operates with more capital. This higher level of expense for the banking system can be offset in part by reducing other expenses, such as compensation and administrative expenses. However, the net effect is still likely to be negative, leading to a need to improve the net return on loans by turning down the least attractive loan opportunities, charging more for those that are taken on, and reducing deposit costs to increase the margin between the interest rates earned on loans and those paid for funding the loans.

The economic recovery in the US is already well under way, though we are clearly on a lower growth, lower wages, lower inflation trajectory for the time being. The US banking system could probably absorb the additional cost of capital, though the downstream effect would almost certainly be to push more financial intermediation and lending – particularly to weaker credits – outside of the banking system. But what about Europe (ex the UK) and Japan? Do you really want to put pressure on any regulatory lever that will contribute drag to their economies?

The TBAC Minutes Do Not Disappoint

TBAC stands for Treasury Borrowing Advisory Committee – a special committee of SIFMA members “comprised of senior representatives from investment funds and banks” who “present their observations to the Treasury Department on the overall strength of the U.S. economy as well as providing recommendations on a variety of technical debt management issues”. For fixed income market wonks, being on TBAC is like being a member at Augusta. Membership is by invitation only (though rumors are it can be subject to lobbying); the quarterly meetings are private (TBAC members and high-ranking Treasury staff only); and the minutes published afterwards can be so oblique that the FOMC minutes seem transparent and downright chatty by comparison.

Despite the secret-handshake nature of the proceedings (which is just cool, admit it) the TBAC minutes and documents released almost always contain some interesting information beyond the de rigueur recommended Treasury auction schedule. Below are some excerpts from the minutes of the latest TBAC meeting on November 5^th (formatting added, edited for brevity):

·         Budget deficits forecasts have declined, and that Treasury is likely to be over-financed in FY2015. Specifically the Treasury’s current auction schedule would raise $100 and $200 billion more than the current FY2015 forecasted borrowing estimates from primary dealers and the CBO, respectively. 

·         Based upon these better-than-expected deficits and near-term fiscal projections for FY2015, the Committee recommended that Treasury initiate $1 billion cuts to both the 2- and 3-year coupon auction sizes beginning in November. 

·         Treasury’s borrowing needs would increase again in 2016.

·         While Treasury would normally address a short-term decline in borrowing needs by reducing bill issuance, Treasury officials recommended that Treasury and the Committee should instead consider the possibility of cuts to coupon security issue sizes.  This consideration is warranted as Treasury bills comprise just 11 percent of marketable debt outstanding and that further large reductions could have implications for the functioning of short-term markets, given investors’ persistent and strong structural demand for short-term high-quality liquid assets.

·         Editor’s note: It would be particularly risky to cut T-bill issuance in 2015 when the FOMC is expected to begin raising rates and will be draining a lot of liquidity out of the short-end of the market. A fact no doubt considered by the Treasury and TBAC.

At the previous meeting, TBAC was charged by Treasury to provide an update on trends in the student loan market over the last several years. Below are excerpts of their condensed response in the minutes. The full presentation can be found here.

·         The balance of outstanding student loans has grown from $1.0 trillion as of the end of 2011 to $1.3 trillion as of mid-2014. 

·         Four key factors that continue to drive student loan growth:

1.       Students’ broadly choosing to consume more years of higher education, in part reflecting demographic change with growth in the 20-34 year old cohort;

2.       A greater proportion of students utilizing the federal student loan program (48 percent as of 2012, up from 33 percent in 2002);

3.       Increases in the cost of higher education exacerbated by reduced subsidies from state governments to in-state schools; and 

4.       Outstanding loan balances declining at a slower rate than originally anticipated due to both increased volume of loans in deferral and forbearance as well as longer loan tenors.

·         Default rates are high and rising, with the two-year cohort default rate increasing to 10.0 percent as of 2011 versus 8.8 percent in 2009. 

·         “Default” in the context of federal student loans is generally defined as 270 days without payment and that loans in default represent 9 percent of the stock of outstanding federal student loans.

Editor’s note: Wow. A 10% default rate outside of financial crisis is the land of sub-prime lending. Years ago during the financial crisis I briefly covered asset-backed securities, and when the universe of credit card defaults rose above 10% - to eventually hit just below 12% - it was a historic default wave.

·         The member suggested that students are taking out student loans because higher education has historically been correlated with upward economic mobility.  However, the member noted an average of 40 percent of students at four-year institutions (and 68 percent of students in for-profit institutions) currently do not graduate within six years.  As a result, most likely do not benefit from higher incomes associated with education yet face the burden of student debt.

·         Unlike all other indebtedness, student debt cannot be extinguished in bankruptcy in almost all cases and the government can garnish income tax refunds, Social Security and other federal benefits.

Editor’s note: Despite some caterwauling from a few progressive Senators (I’m side-eyeing you, Elizabeth Warren) there is a very good reason that student loan debt can’t be discharged in bankruptcy – because both the moral hazard risk and economic consequences for taxpayers are enormous. Borrowers could declare bankruptcy immediately following graduation, when they were young and had virtually zero assets to pay off the debt.  The default would then be expunged from their credit histories within 7 years, or most likely by their 30^th birthdays – effectively sticking taxpayers with the cost of their educations. Speaking of cost:

·         The member noted that CBO calculations indicate that the student loan program will deliver a $135 billion profit to taxpayers over the next decade. However, it was observed that the estimate is based on the programs as legislated and does not factor in market risk or shifts in macroeconomic conditions, thereby ignoring the impact of potential defaults.  The estimate does not include the potential cost associated with recent proposals to redesign elements of the student lending program, including:  reducing the interest rate on student loans; increasing repayment options; and  addressing the pace of origination with a focus on qualifying institutions eligible for such programs.  The member noted that under an alternative fair-value accounting approach used by CBO, the program results in an $88 billion cost to taxpayers.

·         A robust and spirited discussion followed the presentation.

Yeah, I bet.