The Circle of Power

Pepy's diary 26th March 1666.

Thence alone to Broade Street to Sir G. Carteret by his desire to confer with him, who is I find in great pain about the business of the office, and not a little, I believe, in fear of falling there, Sir W. Coventry having so great a pique against him, and herein I first learn an eminent instance how great a man this day, that nobody would think could be shaken, is the next overthrown, dashed out of countenance, and every small thing of irregularity in his business taken notice of, where nobody the other day durst cast an eye upon them, and next I see that he that the other day nobody durst come near is now as supple as a spaniel, and sends and speaks to me with great submission, and readily hears to advice

Bubbles

In response to the Krugman and DeLong search for a model that explains bubbles and crashes, Arnold Kling suggests a focus on the financial system and its desire to provide households with risky liabilities (mortgages and corporate loans) and safe assets (deposits). As the financial system gets larger, the each side of the financial balance sheet expands. The burst comes when households start to doubt the safety of their assets.

1. Ordinary folks in the nonfinancial sector want to issue risky liabilities (shares of investments in fruit trees, mortgages on houses) and wants to hold riskless assets (demand deposits, money market fund shares).

2. The financial sector obliges by having a balance sheet with risky assets and supposedly riskless liabilities. The bigger the financial sector gets, the more euphoric the investment climate, because nonfinancial folks get to hold more riskless assets and issue more risky liabilities.

3. The financial sector's expansion is based in part on signaling. That is, banks signal that their liabilities are low risk. Signals include fancy buildings, the "FDIC insured" sticker, balance sheets filled with AAA-rated assets, and so on.

4. Financial expansions are gradual, because it takes a while to come up with new signaling mechanisms and to get the credibility of those mechanisms established with investors.

5. Financial crashes are sudden, because once investors lose a little bit of their confidence in financial institutions, their natural instinct is to ask for safer assets (they withdraw money from uninsured banks, or they ask AIG to post collateral). This behavior weakens the financial institutions further, leading to a rapid downward spiral. Today, we are seeing that all sorts of signals are discredited.

Chinese reserves

There is a lot of attention on Chinese huge reserves of US dollars. RBC strategist Brian Jackson suggests that the Chinese authorities are trying to hedge the potential losses from a depreciation of the US dollar against the renminbi by buying commodities. This does a number of things: it provides a hedge (because the value of the commodity rises if the US dollar falls in value); it takes advantage of low current commodity price levels; it creates a stockpile in preparation for future economic recovery. The major risk is that world economic recovery is slower and storage costs eat into the gains.

Here is the Bloomberg story.

Bubbles and Minsky

Paul Krugman give us a starting point to look at the speculation and bubbles. Of course a symmetric model cannot account for the ferocity of the crash. This needs to have more dramatic effects for the forced closure of positions, collateral calls, illiquidity and panic.

Cash and Carry

Reuters has a nice little overview of the futures market.

This “cash-and-carry” strategy rewards market participants with access to storage or finance at the lowest cost. It is providing huge profits for physical commodity merchants, investment banks, and the owners and operators of warehouses and tank farms during the downturn, and helps explain the record profitability from commodity operations reported recently by some of the largest banking and trading groups.

Potential growth

The Economist takes a look at the outlook for US potential growth. The signs that it sees are not good. Interesting overview.

Unfortunately, the outlook for America’s potential growth rate was darkening long before the financial crisis hit. The IT-induced productivity revolution, which sent potential output soaring at the end of the 1990s, has waned. More important, America’s labour supply is growing more slowly as the population ages, the share of women working has levelled off and that of students who work has fallen. Since 1991 the labour supply has risen at an average annual pace of 1.1%. Over the next decade the Congressional Budget Office expects a 0.6% annual increase.

The measurement problem

In our Time assesses the 'measurement problem'. At face value this appears to be much like the issue of unrealistic economic assumptions. The algorithms that work for quantum physics throw up illogical ideas like the cat that is alive and dead at the same time - yet they work! How can these two be reconciled?

Fiscal or monetary policy

Adrian Bell, Chris Brooks and Tony Moore make a comparison of today's financial crisis with one of 1294. There are some fascinating parallels and a natural experiment that compares the English use of tough fiscal measures with the French use of monetary policy.

Furthermore, deprived of access to credit, Edward was forced to rely on heavy taxation and his prerogative rights of purveyance and prise (compulsory purchases of goods). He also over-issued wardrobe bills (essentially government IOUs) to pay for wages and supplies. All of these measures aroused political opposition in England, and contributed to a major constitutional crisis in 1297 (Prestwich 1988). By contrast, Edward’s opponent, Philip the Fair of France, sought to raise money by debasing the French currency, reducing the silver content of the coins by as much as two-thirds. The income (seigniorage) received from these recoinages meant that Philip did not have to resort to direct taxation to the same extent as Edward or incur the same level of debt (Favier 1978). It is possible, however, that the long-term consequences of the expanding money supply for the French economy were more damaging that the medium-term pain of high taxation and debt in England. We would argue that this has considerable modern resonance, as today’s governments begin to grapple with the problem of how to pay for the obligations that they are currently undertaking.

Super-senior CDOs

The second instalment of Gillian Tett's look at the banking crisis includes this,

On November 4, however, Citi suddenly warned that it would report additional losses of between $8bn and $11bn. That was such shocking news that chief executive Chuck Prince resigned. It was also baffling to analysts. Citi was supposed to be expert at measuring credit risk, so how had it managed to misjudge its losses so badly? And why was it still so uncertain about the total bill?

Demchak dialled into the conference call eager to find out. “The issue is super-senior,” one of the executives explained. The problem, he added, was that the bank held on its books $43bn of super-senior risk, linked to CDOs backed by mortgage debt. Citi had previously assumed that the value of those assets was 100 per cent of face value. Now the price was falling.

Super-senior? Demchak could hardly believe his ears. Almost a decade had passed since Krishna Varikooty, Demchak and the rest of the JP Morgan group had invented the term to describe the part of a CDO that was supposed never to default – according to the computer models. Back then, super-senior had seemed a geeky in-joke, so quirky and obscure that only a few technical experts knew what it meant. Now the Citi executives had casually tossed the word into a conference call with hundreds of mainstream investors, analysts and financiers. Demchak didn’t know whether to laugh, cry or just shake his head in wonder. In other circumstances, he might have felt almost proud that his team’s once-obscure brainchild had suddenly burst into the limelight. In fact, he was horrified: the way Citi told the story, super-senior had turned into a scourge that had created most of its unexpected losses.

“How could this happen?” Demchak wondered. During his days at JP Morgan, his team had considered super-senior so safe that it was “more than triple-A”. Even though Demchak himself had gone to great lengths to sell JP Morgan’s super-senior risk to AIG and other insurance groups, he had never imagined that it could pose more than a moderate risk. Nor had he guessed that Citi was holding so much super-senior risk on its own balance sheet. Citi had never discussed the issue before on conference calls nor highlighted it in previous results announcements. “How did this happen?” Demchak asked himself again and again. As he listened to the rest of the call, he got the distinct impression that the Citi managers were almost as baffled as he was

.
This fits well with the idea that it is the safe parts of the CDOs that are the real problem. No one ever thought that they would be worth less than 100%.

Fed balance sheet

The Economist looks at the Fed's profits from taking on risky assets.

Like Wall Street’s finest, the Fed makes money on a spread. Its main source of funds comes from issuing cash, since currency in circulation is, in effect, an interest-free loan by the public to the central bank. The interest it earns on its loans and securities is almost pure profit, or “seigniorage,” most of which it remits to the Treasury.

Keynes and loanable funds

Paul Krugman outlines the argument given by Keynes against the loanable funds theory and the view that increase government borrowing with force up interest rates by 'crowding out' the private sector.

What Keynes pointed out was that this picture is incomplete if you allow for the possibility that the economy is not at full employment. Why? Because saving and investment depend on the level of GDP. Suppose GDP rises; some of this increase in income will be saved, pushing the savings schedule to the right. There may also be a rise in investment demand, but ordinarily we’d expect the savings rise to be larger, so that the interest rate falls:

Here is the diagram that Krugman uses.

The birth of CDOs

Gillian Tett's new book looks at the birth of CDOs and CDS.

Demchak was acutely aware that modelling the risks involved in credit derivatives deals had its limits. One of the trickiest problems revolved around the issue of “correlation”, or the degree to which defaults in any given pool of loans might be interconnected. Trying to predict correlation is a little like working out how many apples in a bag might go rotten. If you watch what happens to hundreds of different disconnected apples over several weeks, you might guess the chance that one apple might go rotten – or not. But what if they are sitting in a bag together? If one apple goes mouldy, will that make the others rot too? If so, how many and how fast?