Monthly Archives: December 2007

BoC cuts rates

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Makes a lot more sense to Central Bankers to cut with a strong currency than a weak one, particularly with the strong currency keeping prices below their inflation targets.

The ECB, however, is looking at 3% cpi, and would rather not see the Fed cut, as they believe that would weaken the $ and bring more criticism from their eurozone exporters, as well as draw more agg demand away from the eurozone, making it that much more difficult politically for the ECB to act within its price stability mandate.

OTTAWA – The Bank of Canada today announced that it is lowering its target for the overnight rate by one-quarter of one percentage point to 4 1/4 per cent. The operating band for the overnight rate is correspondingly lowered, and the Bank Rate is now 4 1/2 per cent.Since the October Monetary Policy Report (MPR), there have been a number of economic and financial developments that have a bearing on the prospects for output and inflation in Canada.Consistent with the outlook in the MPR, the global economic expansion has remained robust and commodity prices have continued to be strong. The Canadian economy has been growing broadly in line with the Bank’s expectations, reflecting in large part underlying strength in domestic demand. However, both total CPI inflation and core inflation in October, at 2.4 per cent and 1.8 per cent respectively, were below the Bank’s expectations, reflecting increased competitive pressures related to the level of the Canadian dollar. The Bank now expects inflation over the next several months to be lower than was projected in the MPR. In the context of exceptional volatility in global financial markets, the Canadian dollar spiked well above parity with the U.S. dollar in November, but it has recently traded closer to the 98-cent-U.S. level assumed in the October MPR.Overall, the Canadian economy continues to operate above its production capacity. Given the strength of domestic demand and weak productivity growth, there continue to be upside risks to the Bank’s inflation projection.However, other developments since October suggest that the downside risks to the Bank’s inflation projection have increased. Global financial market difficulties related to the valuation of structured products and anticipated losses on U.S. sub-prime mortgages have worsened since mid-October, and are expected to persist for a longer period of time. In these circumstances, bank funding costs have increased globally and in Canada, and credit conditions have tightened further. There is an increased risk to the prospects for demand for Canadian exports as the outlook for the U.S. economy, and in particular the U.S. housing sector, has weakened.All these factors considered, the Bank judges that there has been a shift to the downside in the balance of risks around its October projection for inflation through 2009. In light of this shift, the Bank has decided to lower the target for the overnight rate. At its next interest rate decision in January, the Bank will assess all economic and financial developments and the balance of risks. A full projection for the economy and inflation will be published in the Monetary Policy Report Update on 24 January 2008.

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Review of Yellen Speech

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(from an interoffice email)

Karim:
Quite a long one http://www.frbsf.org/news/speeches/2007/1203.html, but here goes, with selected excerpts, headings my own.

If you don’t want to read the rest, one word describes it, DOVISH…if she was voting next week, she’d vote for 50bps.

Warren:
Agreed. Though the heightened inflation risks at the end do add some balance. This is far different from the Bernanke and Kohn speeches, and seems this is what they would have said if they held the same opinion.

Conditions are worse from 10/31/07
When the shock first hit, I expected the reverberations to subside gradually, especially in view of the easing in the stance of policy, so that by now there would have been a noticeable improvement in financial conditions. Indeed, though the reverberations have ebbed at times over the last four and a half months, since the October meeting market conditions have deteriorated again, and indications of heightened risk-aversion continue to abound both here and abroad.Mortgages in particularAlthough borrowing rates for low-risk conforming mortgages have decreased, other mortgage rates have risen, even for some borrowers with high credit ratings. In particular, fixed rates on jumbo mortgages are up on net since mid-July. Subprime mortgages remain difficult to get at any rate.Moreover, many markets for securitized assets, especially private-label mortgage-backed securities, continue to experience outright illiquidity; in other words, the markets are not functioning efficiently, or may not be functioning much at all. This illiquidity remains an enormous problem not only for companies that specialize in originating mortgages and then bundling them to sell as securities, but also for financial institutions holding such securities and for sponsors, including banks, of structured investment vehicles—these are entities that relied heavily on asset-backed commercial paper to fund portfolios of securitized assets.

To assess how financial conditions relevant to aggregate demand have changed since the shock first hit, we must consider not only credit markets but also the markets for equity and foreign exchange. These markets have hardly been immune to recent financial turbulence. Broad equity indices have been very volatile, and, on the whole, they have declined noticeably since mid-July, representing a restraint on spending.

Econ Outlook weaker than expected for longer; She’s not mincing words in this section

The fourth quarter is sizing up to show only very meager growth. The current weakness probably reflects some payback for the strength earlier this year—in other words, just some quarter-to-quarter volatility due to business inventories and exports. But it may also reflect some impact of the financial turmoil on economic activity. If so, a more prolonged period of sluggishness in demand seems more likely.

First, the on-going strains in mortgage finance markets seem to have intensified an already steep downturn in housing.

This weakness in house construction and prices is one of the factors that has led me to include a “rough patch” in my forecast for some time. More recently, however, the prospects for housing have actually worsened somewhat, as financial strains have intensified and housing demand appears to have fallen further.

Moreover, we face a risk that the problems in the housing market could spill over to personal consumption expenditures in a bigger way than has thus far been evident in the data. This is a significant risk since personal consumption accounts for about 70 percent of real GDP. These spillovers could occur through several channels. For example, with house prices falling, homeowners’ total wealth declines, and that could lead to a pullback in spending. At the same time, the fall in house prices may constrain consumer spending by changing the value of mortgage equity; less equity, for example, reduces the quantity of funds available for credit-constrained consumers to borrow through home equity loans or to withdraw through refinancing. Furthermore, in the new environment of higher rates and tighter terms on mortgages, we may see other negative impacts on consumer spending. The reduced availability of high loan-to-value ratio and piggyback loans may drive some would-be homeowners to pull back on consumption in order to save for a sizable down payment. In addition, credit-constrained consumers with adjustable-rate mortgages seem likely to curtail spending, as interest rates reset at higher levels and they find themselves with less disposable income.

Moreover, there are significant downside risks to this projection. Recent data on personal consumption expenditures and retail sales are not that encouraging. They have begun to show a significant deceleration—more than was expected—and consumer confidence has plummeted. Reinforcing these concerns, I have begun to hear a pattern of negative comments and stories from my business contacts, including members of our Head Office and Branch Boards of Directors. It is far too early to tell if we are in for a sustained period of sluggish growth in consumption spending, but recent developments do raise this possibility as a serious risk to the forecast.

Net Exports to weaken along with decoupling

I anticipate ongoing strength in net exports, but perhaps somewhat less than in recent years, since foreign activity may be somewhat weaker going forward. Some countries are experiencing direct negative impacts from the ongoing turmoil in financial markets. Others are likely to suffer indirect impacts from any slowdown in the U.S. For example, most Asian economies are now enjoying exceptionally buoyant conditions. But the U.S. and Asian economies are not decoupled, and a slowdown here is likely to produce ripple effects lowering growth there through trade linkages.

Now for the bright side-

I don’t want to give the impression that all of the available recent data have been weak or overemphasize the downside risks. There are some significant areas of strength. In particular, labor markets have been fairly robust in recent months. As I mentioned before, the growth of jobs is an important element in generating the expansion of personal income needed to support consumption spending, which is a key factor for the overall health of the economy. In addition, business investment in equipment and software also has been fairly strong, although here too, recent data suggest some deceleration. Despite the hike in borrowing costs for higher-risk corporate borrowers and the illiquidity in markets for collateralized loan obligations, it appears that financing for capital spending for most firms remains readily available on terms that have been little affected by the recent financial turmoil.

If we cut aggressively, we might grow at trend

To sum up the story on the outlook for real GDP growth, my own view is that, under appropriate monetary policy, the economy is still likely to achieve a relatively smooth adjustment path, with real GDP growth gradually returning to its roughly 2½ percent trend over the next year or so, and the unemployment rate rising only very gradually to just above its 4¾ percent sustainable level. However, for the next few quarters, there are signs that growth may come in somewhat lower than I had previously thought likely. For example, some of the risks that I worried about in my earlier forecast have materialized—the turmoil in financial markets has not subsided as much as I had hoped, and some data on personal consumption have come in weaker than expected. I continue to see the growth risks as skewed to the downside in part because increased perceptions of downside economic risk may induce greater caution by lenders, households, and firms.

Core PCE likely to slow further but still some upside risks

Turning to inflation, signs of improvement in underlying inflationary pressures are evident in recent data. Over the past twelve months, the price index for the measure of consumer inflation on which the FOMC bases its forecasts—personal consumption expenditures excluding food and energy, or the core PCE price index—has increased by 1.9 percent. Just several months ago, the twelve-month change was quite a bit higher, at nearly 2½ percent.

It seems most likely that core PCE price inflation will edge down to around 1¾ percent over the next few years under appropriate policy and the gap between total and core PCE inflation will diminish substantially. Such an outcome is broadly consistent with my interpretation of the Fed’s price stability mandate. This view is predicated on continued well-anchored inflation expectations. It also assumes the emergence of a slight amount of slack in the labor market, as well as the ebbing of the upward effects of movements in energy and commodity prices. However, we do still face some inflation risks, mainly due to faster increases in unit labor costs, the depreciation of the dollar, and the continuing upside surprises in energy prices. Moreover, labor markets have continued to surprise on the strong side. All of these factors will need to be watched carefully going forward.

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Cut mania spreading!

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U.K. Economists Call for Immediate Rate Cut, TelegraphReports

(Bloomberg)U.K. economists urged the Bank of England to cut interest rates as a matter of urgency after the sterling inter-bank market’s fastest decline in modern times, the Daily Telegraph reported. The volume of market loans in the banking system fell from640 bln pounds ($1.3 trillion) at the start of the credit crisis to249 bln pounds by the end of September, the newspaper said.

seems these were absorbed by the banking system, much like in the US?

Tim Congdon, a professor at the London School of Economics, called for a half-point rate cut, to 5.25 %, when the central bank’s Monetary Policy Committee meets on Dec. 5, commenting that a market that’s taken 30 years to build “has completely imploded in a matter of months,” the Telegraph said. Patrick Minford, a professor at Cardiff University, wants a three-quarter-point cut, saying the committee has been “standing idly by” as three-month London Inter-Bank Offered Rate spreads shot up by 75 basis points; he described the central bank’s behavior as “highly irresponsible, neglecting a century of monetary teaching,” the newspaper said.

There was no such market a century ago, as above. What the advantage of market loans verses non market loans is to the real economy is never discussed.

If there is a real problem, it would be real borrowers no longer able to obtain credit. That’s never discussed as a reason to cut.

Peter Warburton, of Economic Perspectives, called for a half-point cut at once and a further easing in the new year, the Telegraph added.

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Chairman Bernanke on Food and Energy Prices

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Letter to Editor of the Wall Street Journal that was never published.

From Mr Warren Mosler.

Dear Sir,

Chairman Bernanke has recently stated the following before Congress:

“…and futures quotes suggest that investors saw food and energy prices coming off their recent peaks next year.”

– Testimony, Chairman Ben S. Bernanke,
“The Economic Outlook” Before the Joint Economic Committee, U.S. Congress, November 8, 2007

It appears from this and previous similar statements that the Chairman is using the “futures market” prices of crude oil as a forecast of what prices are likely to be in the future. This is incorrect.

When a ‘non-perishable’ commodity like oil is in short supply, this condition is expressed by the spot price trading higher than prices for future delivery. When, instead, inventories are plentiful, prices for delivery in the future are higher than spot prices.

Clearly a commodity in short supply is not necessarily less apt to appreciate than a commodity where inventories are plentiful. Yet that is exactly how the Fed model appears to be programmed: the current backwardation in crude oil is viewed as indicative of lower prices over
time, rather than indicative of a product in very short supply, where spot prices can at least as easily go up as down.

Yours faithfully,

Warren Mosler
Senior Associate Fellow,
Cambridge Centre for Economic and Public Policy,
University of Cambridge,
Chairman,
Valance Co. 5000 Estate Southgate
Christiansted, St. Croix, USVI 00820
Office phone: 340 692 7710
E-Mail: warren.mosler@gmail.com

Professor James K. Galbraith
Lloyd M. Bentsen, Jr. Chair in Government/Business Relations
LBJ School of Public Affairs
The University of Texas at Austin
Austin TX 78713-8925

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2007-12-03 US Economic Releases

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ISM was the big number – not a lot of new US numbers today.

Unch; but employment component down 4.2pts to below 50 and anecdotes not very comforting

and prices paid up, see below.

What Respondents are Saying..

  • “Continued concerns regarding high oil prices, weak dollar and weak housing sector.” (Chemical Products)
  • “Erratic market causing more difficulty in forecasting customer demand.” (Computer & Electronic Products)
  • “Heavy truck market has not started recovering yet.” (Fabricated Metal Products)
  • “Business is off by almost 50 percent over last year in the building products industry.” (Nonmetallic Mineral Products)
  • “More inquiries from international customers than domestic.” (Machinery)

The building products industry has been down for quite a while and exports are picking up the slack.

ISM Manufacturing (Nov)

Survey 50.8
Actual 50.8
Prior 50.9
Revised n/a

ISM Prices Paid (Nov)

Survey 65.5
Actual 67.5
Prior 63.0
Revised n/a

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Saudis are Necessarily in Position of Price-Setter

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Published November 16, 2007 in the Financial Times

From Mr Warren Mosler.

Sir, Adrian Binks’ letter “Oil price conspiracy theories get in the way of facts”(November 14) is precisely the response indicated in my letter (November 12); in this case from an energy information service. While Mr Binks’ statements are indeed factual, the institutional structure outlined, which the Saudis initiated, leaves more than sufficient room for the Saudis effectively to set prices and meet the demand at that price.

Note that their current production level of about 8.5m barrels per day is down about 2m bpd from just a few years ago. If they were simply producing based on capacity and selling the resulting output at “market” prices, their output would be higher and the price of crude much lower.

Furthermore, if they were not acting as swing producer, it would be far more difficult to organize general Opec production levels.

Regarding Russia, Mr Binks’ statement that “the Kremlin proposed that an oil exchange be established at St Petersburg to set the price of Russian oil, although this has not yet come into being”, is indicative that President Vladimir Putin is well aware that Russia is indeed a “price-setter”, and I suggest that it is an error to underestimate his progress in this direction.

To address Mr Binks’ conclusion: this is not a “conspiracy theory” and not precisely a “price-setting cartel”. It is, rather, a point of logic describing a case of “imperfect competition” where (at least in the short run) a given supplier’s output is sufficiently large and flexible, and demand sufficiently constant, that the supplier is necessarily in the position of “price-setter”.

Warren Mosler,
Chairman,
Valance & Co,
St Croix,
USVI 00820

Copyright The Financial Times Limited 2007

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Oil Price Conspiracy Theories Get in the Way of Facts

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Published November 14, 2007 in the Financial Times

From Mr Adrian Binks.

Sir, Warren Mosler (Letters, November 12), reveals the level of hysteria that affects even intelligent western economists when it comes to oil prices.

First, economists need to understand the facts. Saudi Arabian crude oil is sold at prices directly linked to market values. Sales to Asia are linked to the price of Oman and Dubai crude, with exports to Europe based on ICE Brent futures prices, and sales to the US ultimately linked to West Texas Intermediate crude price levels. The Saudis set monthly differentials to these benchmark market prices that reflect the different quality of their crude, taking into account their customers’ refinery configurations.

Mr Mosler is equally confused when he writes that President Vladimir Putin “seems to have gained control over pricing of Russian oil”. Most Russian crude oil is sold at market-related prices. In the case of the second largest private-sector Russian producer, TNK-BP, next year’s sales will be based on the average of market assessments by Argus and Platts, two international specialist reporting agencies.

The trend within Russia is to greater market-related pricing, not less. The Kremlin proposed that an oil exchange be established at St Petersburg to set the price of Russian oil, although this has not yet come into being.

Rather than producer price setting, the cause of the upsurge in oil prices is new demand in China and India, coupled with the inability of western oil companies to invest in new low-cost reserves because of state control of crude oil extraction in key exporters. This is nothing new. Saudi oil production has been closed to western oil companies since the 1970s.

What is new is the drive for cleaner-burning transport fuels that require massive investment by the oil industry in more sophisticated refining. At the same time, there is a huge increase in product demand in markets to which western companies have little access.

These are the facts that economists in western countries should be focused on, and not conspiracy theories about price-setting cartels.

Adrian Binks,
Chief Executive,
Argus Media,
London EC1V 4LW

Copyright The Financial Times Limited 2007

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Saudis Do Set World Oil Prices – Despite Bold Denials

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Published November 12, 2007 in the Financial Times

From Mr Warren Mosler.

Sir, As crude oil prices continue to rise, the media continue to assume that competitive market forces are behind the increase, including political tensions, weather, supply disruptions and demand pressures. Completely overlooked, however, is the fact that the Saudis post their offered prices for the oil they sell to their refiners, and let the quantity they deliver vary with demand. It is a simple case of monopoly price-setting. The Saudis are acting as “swing producer” and setting the world price.

As a point of logic, the Saudis have no choice but to set the price of oil. At the margin, they are in fact the sole supplier of about 8.5m barrels of crude that the world currently needs from them every day. As all economics students are taught, any sole supplier is necessarily a “price-setter”.
Of course, the Saudis boldly deny that they set prices. However, they do say they do not sell in the spot markets, but that they do (publicly) post their desired prices to the refiners who buy their oil.

The Saudis will continue as price-setter until net world supply increases sufficiently to cause Saudi sales to fall and production to drop to unsustainably low levels. This is what happened in the early 1980s and persisted until the last several years when a decrease in net available world supply put the Saudis back in the driver’s seat.

Additionally, President Vladimir Putin seems to have gained control over pricing of Russian oil, making him a world “price-setter” as well. This means that either the Saudis or the Russians can raise prices at will, and the rest of the market automatically follows.

The bottom line is that the price of oil will rise to the higher of any price Russia or the Saudis desire, with no relief unless there is a drop in net world demand that reduces the demand for both Saudi and Russian output to unsustainably low levels.

Warren Mosler,
Chairman,
Valance,
St Croix, USVI 00820
(Senior Associate Fellow, Cambridge Centre for Economic and Public Policy, University of Cambridge, UK)

Copyright The Financial Times Limited 2007

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Feds’ budget tricks hide trillions in debt

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Feds’ Budget Tricks Hide Trillions in Debt

-Scott Burns
Every year, tens or even hundreds of billions of dollars are quietly added to the national debt — on top of the deficits that we hear about. What’s going on here?

Burns doesn’t get it.

When it comes to financial magic, the government of the United States takes the prize. Sleights of hand and clever distractions by purveyors of line-of-credit mortgages, living-benefit variable annuities and equity-indexed life insurance are clumsy parlor tricks compared with the Big Magic of American politicians.Consider the proud trumpeting that came from Washington at the close of fiscal 2007. The deficit for the unified budget was, politicians crowed, down to a mere $162.8 billion.

In fact, our government is overspending at a far greater rate. The total federal debt actually increased by $497.1 billion over the same period.

But politicians of both parties use happy numbers to distract us. Democrats routinely criticize the Republican administration for crippling deficits, but they politely use the least-damaging figure, the $162.8 billion. Why? Because references to more-realistic accounting would reveal vastly greater numbers and implicate both parties.

No, because they are right and Burns is wrong.

You can understand how this is done by taking a close look at a single statement on federal finance from the president’s Council of Economic Advisers. The September statement shows that the “on-budget” numbers produced a deficit of $344.3 billion in fiscal 2007. The “off-budget”> numbers had a surplus of $181.5 billion. (The off-budget figures are dominated by Social Security, Medicare and other programs with trust funds.)

Correct. Net government spending in the non government sectors is what ‘counts’. Intergovernment transfers of anything are of no economic consequence to the rest of us. They have no current year impact on aggregate demand.

Combine those two figures and you get the unified budget, that $162.8 billion. In the past eight years we’ve had two years of reported surpluses and six years of reported deficits. Altogether, the total reported deficit has run $1.3 trillion.But if you examine another figure, the gross federal debt, you’ll see something strange. First, the debt has increased in each of the past eight years, even in the two years when surpluses were reported. Second, the gross federal debt, which includes the obligations held by the Social Security and Medicare trust funds, has increased much faster than the deficits — about $3.3 trillion over the same eight years.

They are correct, as above, by not including transfers of securities from one government agency to another.

That’s $2 trillion more than the reported $1.3 trillion in deficits over the period. Can you spell “Enron”?

Pass on the comebacks and go on to the text.

In other words, while our reported deficits averaged $164 billion over the past eight years, government debt increased an average of $418 billion a year. That’s a lot more than twice as much. How could this happen?

How can a responsible new sight publish this nonsense???

Easy. The Treasury Department simply credits the Social Security, Medicare and other trust funds with interest payments in the form of new Treasury obligations. No cash is actually paid.

Why should it be???

The trust funds magically increase in value with a bookkeeping entry.

That’s all the $ is in any case – a bookkeeping entry. Get over it!

It represents money the government owes itself.

Right, which has no current year effect on the real economy. It changes buys or sells of real goods and services.

So what happens if we take out the funny money?

What does ‘take out’ mean? Simply transferring from one account at the the fed to another. More entries. Can’t be anything more. That’s all the $ is.

When the imaginary interest payments are included, Social Security and Medicare are running at a tranquilizing surplus (that $181.5 billion mentioned earlier). But measure actual cash, and the surplus disappears.

What is ‘actual cash’???

In 2005, for instance, the Social Security Disability Income program started to run at a cash loss. 2007 is the first year that Medicare Part A (the hospital insurance program) benefits exceeded income.

The same thing will happen to the Social Security retirement-income program in six to nine years, depending on which of the trustees’ estimates you use. During the same period, the expenses of Medicare Part B and Part D, which are paid out of general tax revenue, will rise rapidly.

Point???

Despite this, the Social Security Administration writes workers every year advising them that the program will have a problem 34 years from now, not six or nine years. In fact, the real problem is already here. It will be a big-time problem in less than a decade.

Define ‘big time’. Government going to bounce checks? If the government runs deficits in the out year that are ‘too large’ the evidence will be inflation, not solvency. If he thinks there’s a potential inflation issue, fine, but he doesn’t or he would have said it.

Count on it.

Count on more of this nonsense.

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Review of Kroszner Speech

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Governor Randall S. Kroszner
At the Philadelphia Fed Policy Forum, Philadelphia, Pennsylvania
November 30, 2007

Innovation, Information, and Regulation in Financial Markets

Good afternoon. I am pleased to participate in the excellent annual Philadelphia Federal Reserve Policy Forum to discuss this year’s timely topic of innovations in financial markets. Innovations in financial markets have created a wide range of investment opportunities that allow capital to be allocated to its most productive uses

This is highly questionable but assumed by the fed to be true. The allocation is necessarily a function of the market forces operating within the legislated institutional structure.

and risks to be dispersed across a wide range of market participants. Yet, as we are now seeing, innovation can also create challenges if market participants face difficulties in valuing a new instrument because they realize that they do not have the information they need or if they are uncertain about the information they do have. In such situations, price discovery and liquidity in the market for those innovative products can become impaired.

Yes, that has been the fed’s issue for the last three months. What they call ‘market functioning’ as related to the real economy.

In my remarks today, I would like to explore the role of information in the development of new financial products and then draw some lessons about risk management and regulation. In particular, I will examine the role that investment in information gathering, processing, and evaluating plays in supporting the price discovery process and how such investment can lead toward a tendency to greater standardization as markets for innovative financial products mature. Examples from both history and current experience will help to illustrate this tendency with respect to loan work-outs and restructurings. I will then conclude by considering how a regulatory approach that encourages transparency and sound risk management, such as Basel II, can be valuable in fostering a robust environment for the introduction of innovative financial products.

Experimentation and Learning in New Instrument Development

Typically, when a new product is being developed, there is an initial experimentation phase in which market participants learn a great deal about the product’s performance and risk characteristics. This phase involves gathering and processing information and modeling the performance of the product in various scenarios and under different market conditions. It may then take time for market participants to understand what, exactly, they need to know to value a product. During the early phases, a fair amount of due diligence is appropriate, given the greater uncertainty associated with innovative products. The investment in gathering, processing, and evaluating information then, as I will discuss, often leads to greater standardization of products and contract terms, which can enhance liquidity of products as their markets mature.

In the initial experimentation phase, the terms and characteristics of a new product are adjusted in response to market acceptance–or lack thereof. During this period, market participants are seeking and providing information so that they can properly value the product, judge its potential for risk and return, assess its market acceptance and liquidity, and determine the extent to which the risks of the product can be hedged or mitigated.

When a product’s track record is not well established, there should be a strong market demand for information in order to facilitate price discovery. Price discovery is the process by which buyers’ and sellers’ preferences, as well as any other available market information, result in the “discovery” of a price that will balance supply and demand and provide signals to market participants about how most efficiently to allocate resources. This market-determined price will, of course, be subject to change as new information becomes available, as preferences evolve, as expectations are revised, and as costs of production change.

In order for this process to work most effectively, market participants must utilize information relevant to value that product. Of course, searching out and using relevant sources of information–as well as determining what information is relevant–has its own costs. To underscore the last point, with new instruments, it may not even be clear exactly what information is needed for price discovery–that is, some market participants may not know what they do not know and they may therefore terminate the information-gathering stage prematurely, unwittingly bearing the risks and costs of incomplete information.

He leaves out the fact that fed member banks are specifically designated to be outside this process. They lend based on internal credit analysis based on standards set by federal regulators. The loans are reviewed continuously regarding the borrower’s ability to make timely payment of principal and interest, both short term and long term. If these are not deemed adequate, loans must be ‘qualified’ and banks must add to their loss reserve. for all practical purposes, banks must have government insured liabilities which exert no ‘market discipline’ on assets, and therefore government regulation is required to fill that function. This system operates independently of market pricing of these bank assets. Market discipline comes via shareholders in first loss position with regulators determining appropriate capital ratios. Over the years, this has proved a much more stable platform for credit expansion.

The current problem areas are the ‘market price’ based activity that is outside of the above standard bank model. One result has been a short decline in commercial paper, for example, and a corresponding increase in bank lending, as the underlying lending has been replaced by traditional, nonmarket, bank lending, and credit analysis.

Price Discovery

Due diligence is an important part of the price discovery process. The due-diligence process allows market participants to “trust but verify”market-provided information through a range of activities, from assessing risks and exposures through stress-testing to assessing the enforceability of the contracts that define the legal relationship among originators, sponsors, investors, and guarantors. The due diligence is complemented by risk-management structures that allow participants to interpret, understand, and act appropriately in response to the information in the market.

Recently we have seen how a lack of information and inadequate due diligence and risk management have created problems in the market for certain structured finance products. Let me focus a moment on structured investment vehicles, or SIVs. SIVs have been created with a variety of terms and characteristics–for example, different underlying assets, different levels of liquidity support or guarantees, and various triggers that require the forced sale of assets or liquidation of the structure. Although SIVs or similar vehicles have existed for many years, many recent SIV structures involved a much higher level of complexity of the underlying credit risks, legal structures, and operations. This complexity–and the lack of information about where the underlying credit, legal, and operational risks resided–made these products more difficult and costly to value than many investors originally thought. Investors suddenly realized that they were much less informed than they assumed and, not surprisingly, they pulled back from the market.

The better way to state this is that risk was repriced. The spreads got wide enough for banks to underwrite and ‘absorb’ the loan demand. That’s how those markets function under current institutional structure.

We have seen similar problems in the subprime residential mortgage-backed securities market and the related derivatives markets. The lack of long historical data on the performance of these instruments, and their correlations with other assets and instruments, made it difficult to assess their overall risk-return profile, especially in times of stress. Moreover, in the subprime residential mortgage-backed securities market, many market participants were willing to proceed without conducting robust due diligence and without establishing appropriate risk-management structures and processes.

This means they priced the risk low enough to ‘win’ the right to invest. They changed their minds, and at that point owned over priced securities, to be sold only at lower prices/higher yields.

Same below..

They did not follow “trust but verify,” that is, they instead accepted the investment-grade ratings of these securities as substitutes for their own risk analysis. Ratings keyed to expected default or credit loss do not adequately capture the full range or magnitude of risks to which a product may be subject, including–as we have seen most dramatically–market liquidity risks. In addition, some originators may not have demanded sufficient information about the purchased assets underlying these structures and therefore may not have fully appreciated the credit risk of the assets and the consequential risk that the structures would come back on balance sheet when the assets defaulted.

When the problems in the subprime mortgage market began to emerge and delinquencies exceeded rating agency estimates and the defaults predicted by limited historical data, we had moved beyond our past experience with these instruments. Information was not readily available about the extent to which the economic context had changed, or even whether underlying loans would or could be modified to prevent default. When ratings were downgraded, investors lost confidence in the quality of the ratings and hence the quality of the information they had about subprime investments. Lack of information, a disrupted price-discovery process, and a stressed environment led to a reassessment of risk, not only in the subprime market but also in the residential mortgage market across the board.

Of course, this is not the first time that participants in a market for an innovative product have suffered losses. In the early 1990s, participants in the collateralized mortgage obligation (CMO) market and the markets for structured notes and certain types of interest rate derivatives did not have adequate information about the potential volatility and prepayment risk involved. Consequently, market participants did not appropriately model these risks and suffered significant losses when market interest rates rose sharply in the mid-1990s. As in the case of the residential mortgage-backed securities market today, the general market reaction was a flight away from these instruments. However, over time, the market was restored as market participants came to better understand the risks and as standardized methods were developed to measure the risks and model the value of these instruments under alternative scenarios. Increased information and standardized pricing conventions, such as the use of option-adjusted spreads, moved these instruments from the experimentation and learning phase to the phase of broad market acceptance.

When market participants realize that they do not have the information necessary for proper valuation of risks, the price-discovery process can be disrupted, and market liquidity can become impaired. A significant investment in information gathering, processing, and evaluation may be necessary to revive the price discovery process. This revival is likely to take time and the market may not look the same when it re-emerges.

We’ve had three months since the ‘crisis’ began. We made it through so far. Risk has been repriced. Spreads are wider. Less is trading which is not necessarily a ‘bad thing’ at the macro level. Banks are lending aggressively directly to borrowers in good standing.

Let me describe in a bit more detail the ways in which these investments will take place and hence why recovery of price discovery may be a gradual process. First, market participants will likely need to collect more-detailed data in a more systematic manner in order to better understand the nature and risks of the instruments and their underlying assets. Second, investments in enhanced systems to warehouse and model data related to these instruments will facilitate a better understanding of their risks, particularly under stress conditions. Third, investors need to ensure that they have the so-called human capital expertise–that is, the people–to underst and, interpret, and act appropriately on the results of the modeling and analysis of the information gathered. The pay-off from these investments will be a greater understanding of risks and greater ability to value the instruments.

Yes, and that’s why it took several weeks for the banking system to ‘absorb’ market based lending. That process is now well underway.

The Development of Greater Standardization in a Market

Another consequence of information investments is a tendency towards greater standardization of many of the aspects of an instrument, which can help to increase transparency and reduce complexity. As was demonstrated in the CMO market, as the market gains information about a product and develops a level of confidence in that information, the product tends to become increasingly standardized. Standardization in the terms and in the contractual rights and obligations of purchasers and sellers of the product reduces the need for market participants to engage in extensive efforts to obtain information and reduces the need to verify the information that is provided in the market through due diligence. Reduced information costs in turn lower transaction costs, thereby facilitating price discovery and enhancing market liquidity. Also, standardization can reduce legal risks because litigation over contract terms can result in case law that applies to similar situations, thus reducing uncertainty.

The benefits of the development of standardization for enhancing the liquidity of financial markets have a long history. One particularly clear example dates back to the development of exchange-traded commodities futures contracts in the mid-1800s. The standardization of the futures markets improved the flow of information to market participants, reducing transaction costs and fostering the emergence of liquid markets.

Fostered an army of traders who could have been out curing cancer or something else more useful. Little or none of the ‘financial innovation’ has led to more efficient allocations of real resources, but instead has absorbed the brightest and best in to the world of ‘rearranging of financial assets’ encouraged under current institutional structure, including tax law and tax advantage savings programs under the misguided notion that ‘savings is needed to provide funds for investment’ as every economist is (or at one time was) well aware.

In the early days of the Chicago Board of Trade, in the mid-1850s, standardization took the form of creating “grades” or quality categories for commodities such as wheat, allowing for the fungibility of grains stored in elevators and warehouses, and breaking the link between ownership rights and specific lots of a physical commodity.Traders no longer needed to verify that a certain quantity of grain was of a sufficiently high grade because the exchange established a system of internal controls in the form of grain inspectors and a self-regulatory system to arbitrate disputes. The grain inspectors charged a set fee to certify the quality of the grain for any receipt traded at the board, a system with parallels to the mechanisms employed today by the rating agencies.1

In effect, standardization and related controls reduced traders’ information requirements and, thus, their transaction costs. In 1865,the Chicago Board of Trade standardized the delivery dates for the contracts, thus fostering the emergence of liquid markets in which traders could readily hedge the risk of price changes in the commodities and contracts. A final step toward standardization came years later with the adoption of the clearinghouse for the exchange as the common counter party to all of the contracts traded on the exchange. With a central counterparty, the costs and uncertainties of failures and restructurings were significantly reduced, thereby reducing work-out costs and enhancing liquidity of the contracts traded on the exchange.2

As above, for what further purpose??? He is treating ‘market functioning’ as an end rather than a means with a proper cost/benefit analysis.

The benefits of standardization can be realized not only on organized exchanges but also in over-the-counter markets. In more recent times,for example, the creation of the International Swaps and Derivatives Association (ISDA) master agreement for over-the-counter swaps and derivatives contracts has brought about the benefits of standardization while also allowing for product flexibility and customization. The ISDA master agreement provides standard definitions and a general outline for the contract but allows latitude in customizing terms. The master agreement also sets forth a template for workout procedures if a counterparty defaults, allowing parties to the agreement to adjust their risk-management strategies in light of the agreed-upon work-out process. This standardization reduces uncertainty about the instruments, which lowers transaction costs and facilitates price discovery and market liquidity.

Yes the most efficient structures would be a futures contract which the dealers have successfully blocked over the years.

The examples from the long- and more recent- past may hold some valuable lessons for how improvements in standardization could help to address some of the challenges in the subprime market. Uncertainty about the work-out process and the options that are available, for example, could be contributing to the difficulties in reviving price discovery and liquidity in the market for subprime residential mortgage-backed securities.

How about just let the banks underwrite the mtgs to regulatory standards???

Part of the valuation challenge is gauging the extent of the difficulties that borrowers will have in making payments and being able to stay in their homes given the reduction in house price appreciation–or actual declines in some areas–and the large number of interest rate resets coming on many adjustable-rate mortgages. From now until the end of next year, monthly payments for an average of roughly 450,000 subprime mortgages per quarter are scheduled to undergo their first interest rate reset. In addition, tightening credit conditions as reported in the Federal Reserve’s Senior Loan Officer Opinion Surveys on Bank Lending Practices suggest that refinancing may become more difficult.

Lenders and servicers generally would want to work with borrowers to avoid foreclosure, which, according to industry estimates, can lead to a loss of as much as 40 percent to 50 percent of the unpaid mortgage balance. Loss mitigation techniques that preserve homeownership are typically less costly than foreclosure, particularly when applied before default. Borrowers who have been current in their payments but could default after reset may be able to work with their lender or servicer to adjust their payments or otherwise change their loans to make them more manageable.

The govt has to either ban the origination of adjustable rate mtgs but not legally enforcing any such contracts or face the consequences of allowing them, which we are seeing. Either you believe in that much personal freedom and risk taking or you don’t.

It is imperative that we work together as a financial services community to look for ways to help borrowers address their mortgage challenges, particularly for those who may have fewer alternatives, such as lower-income families. The Federal Reserve and other regulators have been active in encouraging lenders and servicers to take a proactive approach to work with borrowers who may be at risk of losing their homes. For example, the agencies have issued statements underscoring that prudent workout arrangements that are consistentwith safe and sound lending practices are generally in the long-termbest interest of both the investor and the borrower and have had numerous meetings with interested parties to foster the development and implementation of work-out arrangements.

Given the substantial number of resets from now through the end of 2008, I believe it would behoove the industry to go further than it has to join together and explore collaborative, creative efforts to develop prudent loan modification programs and other assistance to help large groups of borrowers systematically. I am not suggesting a one-size-fits-all approach, but a bottom-up approach designed to appropriately balance the needs of all parties. Getting to borrowers who have been making payments but are at risk of falling behind before they actually do become delinquent, for example, can help to preserve work-out and refinancing options.

Some industry participants and consumer groups have begun to work collaboratively to develop loan-modification templates, standards, and principles that can help to streamline the work-out and modification process. This can reduce transaction costs and potentially provide timely relief to a wider range of borrowers. A systematic approach to loan modifications would likely reduce some of the uncertainties in the market for such subprime mortgage-backed securities, helping to restore price-discovery and liquidity. This would help to ease the tightening of credit conditions in the market.

I am privileged to serve as a board member of Neighbor Works America, anational nonprofit that partners with the HOPE NOW Alliance. This alliance is developing ways to facilitate the flow of information between servicers and distressed borrowers and to work toward clarification of loan-modification procedures. Increased standardization and certainty could also benefit investors in the mortgage market by improving information flows and the price-discovery process, thereby improving market liquidity while at the same time helping to avoid foreclosures and promoting sustainable homeownership.

A Regulatory Environment That Encourages Sound Risk Management and Transparency

Recent market events have underscored the need for better market information about new products, robust due diligence to verify that information, and risk-management strategies to utilize the information in management decision making. The supervisory agencies and the industry both are addressing the need for improved risk management in light of the market disruptions The newly adopted Basel II capital framework for large internationally-active banking organizations, for example, is an important advance that encourages the types of investment in information I discussed earlier. The Basel II framework is comprised of three pillars. Pillar 1 requires information gathering and robust modeling techniques to better take into account the risks of different types of instruments and securities than under the traditional Basel I framework. It also provides incentives for more robust risk management in connection with certain higher-risk activities, such as securitization and other off-balance-sheet activities. Pillar 2 emphasizes the further stress testing and analysis of the data in conjunction with an ongoing evaluation of the institution’s capital adequacy in light of its risks through the internal capital adequacy assessment process. Pillar 3 reflects the need for better information through investments in data gathering and analysis that are reflected in enhanced public disclosures and regulatory reporting. More-comprehensive and more-transparent information allows investors to better understand the banking organization’s risk profile and thus reduces transaction costs and facilitates price discovery and market liquidity. The three pillars of Basel II promote precisely the three types of investment in information discussed earlier that facilitate the price discovery process.

In addition to supervisory initiatives, industry leaders’ efforts to influence the adoption of sound practices and codes of conduct can efficiently and effectively facilitate market-correcting behaviors. To this end, the industry is actively engaged in efforts to improve sound practices for risk management through improved stress-testing practices to cover contingent exposures, marketwide events, and potential contagion and enhanced due diligence and modeling for new products. As they look into the causes of the recent market disruptions and determine the appropriate response, both supervisory and industry groups are carefully analyzing the weaknesses in risk management and the lack of transparency in complex structures–and the implications of that lack of transparency for proper valuations.

Conclusion

The recent market disruptions have dramatically underscored the importance of gathering and analyzing information about innovative products. When the price-discovery process for a product is disrupted, both investors and sellers need to engage in a period of information gathering, processing, and analysis in order to re-establish a market price. This can be a gradual process and one that results in fundamental changes to the market for the product. Efforts underway by both supervisors and the industry should encourage improvements in risk analysis and management and, thus, price discovery. We are hopeful that our efforts to increase the standardization of loan-modification options and processes for subprime loans will help to provide more information to lenders, investors, homeowners, and communities faced with potential mortgage loan defaults while at the same time helping to provide more timely relief for borrowers in distress.

Footnotes
1. See Randall S. Kroszner (1999), “Can the Financial Markets Privately Regulate Risk? The Development of Derivatives Clearing Houses and Recent Over-the-Counter Innovations,” Journal of Money,Credit, and Banking, vol. 31 (August), p. 600. Return to text
2. See Kroszner, “Can the Financial Markets Privately Regulate Risk?”, p. 601.

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