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.

Market-Friendly Priorities: Tax Reform, Trade and Energy

The "not quite final" Senate tally: Democrats 44, Republicans 54, Independents 2.

• Once the Alaska and Louisiana elections are settled - both of which are expected to be won by the Republicans - the simple majority of the Senate will shift in favor of the Republicans for the next Congress. Both Independents currently caucus with the Democrats, so the party-line voting split will likely be 54 - 46.
• This will give the Republicans a similar majority in the Senate in 2015-2016  to that currently held by the Democrats, which is Democrats 53, Republicans 45, Independents 2.
• Even if the Independent senator from Maine crosses over occasionally to vote with the Republicans, that would still leave the party-line vote at 55-45, far from the 60 votes needed to thwart a filibuster in the Senate and pass contentious legislation.
• Perhaps more importantly for the upcoming Congress, it's not anywhere near the two-thirds majority (67 Senate votes, 290 House votes, assuming all members of Congress vote) needed to override a Presidential veto.
• Remember, Senators serve 6-year terms. So all Senators elected during the 2014 midterms will serve through the final two years of President Obama's term plus the full four year term of the President elected in 2016.

The "not quite final" House tally: Democrats 187, Republicans 248, Independents 0.

• The Republicans are set to increase their current majority in the House from 233 seats to 248 seats of the 435-member House (218 seats is required for a majority).
• House terms are only for 2 years; so all members of the House are up for re-election every election cycle.

The majority party sets the legislative agenda in that chamber of Congress.

• Being the minority party in either the House or the Senate sucks. Being the minority party when the majority controls both chambers of Congress? Sucks even worse. Just ask the Republicans how they felt after the 2008 and 2010 elections.
• Why? Because the majority party gets to appoint the leadership of the legislative committees in its chamber. The committee leadership controls the calendar, effectively controlling what legislative efforts will be discussed, proposed, voted on and passed to the full chamber from their committee. All of the committees will have the majority of their members from the party that holds the majority.  If a member is in the minority party, getting a piece of legislation e.g. out of the committee and onto the Senate floor requires at least enough support from the majority party for it to pass a vote in committee. In practice this means any legislation proposed by a minority member must typically have broad bi-partisan support to advance in a chamber. 

A bi-partisan agenda: tax reform, immigration, trade and energy.

• The Wall Street Journal (link above) has the best article I've read so far on what the Republican's likely priorities will be - and can be - now that they have solid but not overwhelming control of Congress.
• Very briefly, it may result in somewhat lower corporate taxes, an easier immigration policy that favors businesses, improved trade with Asia, and passage of the Keystone pipeline.
• I'm not good at political analysis, since it always surprises me that some politicians are willing to cut off their nose to spite their face (see: Tea Party Republicans in the House). We can only hope that Boehner, McConnell and Obama will put accomplishing an agenda together ahead of recriminations, partisan stonewalling and personal gain.  ... Hahahaha! Yeah, I don't think so either, but I'll hold out hope for the next 36 hours at least.

Coming up - the Treasury quarterly refunding.

Budget Deficit Shrinks; Long-Term Economic Trajectory Still Unstable

Budget deficit for 2014 has declined. For FY 2014 the budget deficit was $483 billion, or 2.8% of GDP. The Treasury published its quarterly economic policy statement yesterday for the fourth quarter of 2014, which coincides with the end of the 2014 federal fiscal year (October 1, 2013 - September 30, 2014). The FY 2014 budget deficit came in at $483 billion, versus Congressional Budget Office projections of $506 billion (as of August 2014). From the Treasury,

"The strengthening of economic conditions in recent years has occurred alongside a faster-than-expected reduction in the federal government budget deficit.  During the fiscal year that ended in September 2014, the budget deficit declined $197 billion to $483 billion, $100 billion lower than projected in the July Mid-Session Review.  The FY 2014 deficit was equivalent to 2.8 percent of GDP, the lowest share since 2007.  A combination of fiscal retrenchment and faster economic growth have lowered the deficit as a share of the economy by 7 percentage points from a peak of 9.8 percent in FY 2009 – the most rapid improvement in any five-year period since the demobilization after World War II."

I'm not sure why the Treasury's July deficit projections were $77 billion higher than the CBOs in August. Possibly due to staff using somewhat different economic estimates and the 1 month lag in updates. But that's just a guess.

• The good news is that the current deficit as a percentage of GDP has fallen to 2.8%, which compares to an average deficit of 3.1% over the past 40 years.
• The bad news is, well, the "rapid improvement" in the deficit that the Treasury sites is only in comparison to the extraordinary deficit spending of the past 6 years. The US taxpayers face a mountain of debt that has grown from the size of the rolling Appalachians to the atmosphere-scraping Himalayans.  
• The worse news is that persistent and growing deficits are projected through 2024, which will continue to pressure total federal debt higher, eventually restraining economic growth and increasing the risk of fiscal crisis (hello, Eurozone).

Unfortunately, deficit spending keeps the federal debt surging higher. Federal debt held by the public has more than doubled from 35% of GDP in 2007 (or $5.0 trillion) to 74% of GDP in 2014 ($12.8 trillion). This is analogous to the balance on a credit card increasing both outright, and as a percentage of annual net income. Every year the cardholder continues to outspend their net income and the amount they owe on their credit card rises.

Spending on entitlement programs to accelerate; cost of debt to rise. The CBO further projects that "persistent deficits through 2024 would push debt relative to GDP even higher," if current laws governing federal taxes and a spending remain unchanged. By far the biggest driver of the debt projections are the government entitlement programs: Social Security, Medicaid and Medicare. From the CBO's budget outlook,

"Between 2014 and 2024, annual outlays are projected to grow, on net, by $2.3 trillion, reflecting an average annual increase of 5.2 percent. Boosted by the aging of the population, the expansion of federal subsidies for health insurance, rising health care costs per beneficiary, and mounting interest costs on federal debt, spending for the three fastest-growing components of the budget accounts for 85 percent of the total projected increase in outlays over the next 10 years:

• Annual spending for Social Security is projected to grow by almost 80 percent. Under current law, outlays for that program would climb from 4.9 percent of GDP this year to 5.6 percent in 2024, according to CBO's estimates.
• Annual net outlays for the government's major health care programs (Medicare, Medicaid, the Children's Health Insurance Program, and subsidies for health insurance purchased through exchanges) are projected to rise by more than 85 percent. Outlays for those programs would grow from 4.9 percent of GDP to 5.9 percent, CBO anticipates.
• Outlays for net interest in 2024 are projected to be more than triple those in 2014—the result of both projected growth in federal debt and a rise in interest rates. Net interest outlays would rise from 1.3 percent of GDP this year to 3.0 percent by the end of the coming decade, CBO expects.

In contrast, taken together, all other spending is projected to grow by only about 20 percent. Relative to GDP, such spending would fall—from 9.3 percent this year to 7.3 percent by 2024, its lowest percentage since 1940 (the earliest year for which comparable data have been reported)."

The CBO's normal budget projections only go out 10 years, but their "long term" projections are even more disturbing, and foreshadow a crippled US economy due to massive social welfare programs that it cannot sustain without either significantly raising taxes, or cutting spending, or both. Think Greece. No, really.

Go vote. Tomorrow the markets may have a glimmer of clarity about which path the country can take out of this financial morass. But glimmers aren't mandates; mandates don't always produce consensus; and even consensus may not translate into legislation. But for now, let's all take the next step and exercise your right to be heard.

Under development: When I learn how to add Excel charts and images to my posts I will add some nifty graphs courtesy of the CBO. Until then, my apologies as I am still learning how to use the blogging templates.

Potential Market Reaction to Midterm Elections

Political disclaimer: Polls aren't that far removed from the Op-Ed section of your favorite paper. Unless there is a terrific attempt to remain unbiased (which is rare), opinion polls can be skewed to generate any outcome or conclusion that conveniently supports your point. I honestly don't know enough about election polling to draw any firm conclusions about the methods, though I do know that in the last cycle the Republicans own polls were laughably and alarmingly misleading. That being said, there does seem to be a breath of a consensus that the Republicans are likely to win a slim majority in the Senate. Other polls claim its all still too close to call. FWIW.

Republicans increasingly likely to take control of the Senate: New polls out over the weekend project a 70% chance that Republicans will take control of the Senate (for a majority of 51 seats) as a result of Tuesday's midterm elections. The current party breakdown in the Senate is:

• Democrats  - 53
• Republicans - 45
• Independents - 2 (both of whom caucus with the Democrats)

Given that both independents caucus with the Democrats, the Republicans need to pick up 6 seats to win unequivocal control of the chamber. Political analysis and election modeling on FiveThirtyEight now projects that Republicans have about a 40% chance of ultimately winning 8 seats in the Senate, (giving them 53 seats) though analysts there expect two seats to require run-off elections.

It's worth noting that even if Republicans take a 53 seat majority, that is far from 60 required to prevent a filibuster, so there is no expectation that a majority Republican Senate would have a carte blanche - or a "mandate" - to pass legislation.

Republicans almost certain to increase their majority in the House: Polls suggest that Republicans are also likely to modestly increase their majority in the House of Representatives by 10 to 12 seats, which they currently hold 234 to 199 (with two seats vacant).

Bullish for equities: There is an interesting Barron's interview with Bob Doll of Nuveen (formerly of BlackRock) which provides his analysis of the equity market's potential reaction to Tuesday's midterm elections,  Midterm Elections: If GOP Wins These Stocks Should Gain. Doll says,

"The midterm elections are huge for the market. During the six-month period that followed each of the past 16 midterm elections, the stock market has gained 16% on average. It isn’t all about which political party wins. Granted, it isn’t unimportant. What’s more important is to actually have the midterm elections and remove uncertainty from the financial markets. The markets don’t like uncertainty, and the midterm elections determine who can craft legislation, spend money and who is best positioned for the presidential election in two years’ time."

He expects that if Republicans do take control of the Senate, the corporate sectors that are likely to gain the most are conventional energy companies (oil), defense contractors and big banks. If Democrats hang onto their majority, the beneficiaries could be alternative energy, hospitals and infrastructure.

Unclear for bonds: Presidential elections have tended to have a stronger impact on the bond market than midterms, though the prospect of a Republican Congress that would lean towards lower spending and tax reform could be supportive of bond prices and keep yields low. From an article titled How Do Elections Affect Bond Market Returns?,

"A 2006 study in the Financial Services Review titled, “Tactical Asset Allocation and Presidential Elections” reported that from 1961 through 2004, long-term government bonds produced an average annual return of 4.14% when a Democrat was in the White House and 10.80% when a Republican was in control. The average annual return for the full period was 7.77%. This gap has since closed, however, as long-term government bonds have performed very well since President Obama was elected in 2008."

Given that midterms are unlikely to provide either party with enough traction to dramatically shift policy, the biggest driver of the bond market will probably continue to be the Fed and economic data.