Command and belief

Paul Krugman looks at the way that belief can augment the command economy within the firm and more broadly.

We see this kind of thing all the time, in microcosm. The market does not require people to believe in it; but the centrally planned economies that live inside a market economy, known as corporations, do. Everybody knows that financial incentives alone are not enough to make a company succeed; it must also build morale, a sense of mission, which makes people work at least somewhat for the good of the company rather than think only of what is good for them. Luckily, under capitalism an individual company can fail without taking the whole society down with it - or it can be reformed without a bloody revolution.

Why did people stop believing in socialism? Part of the answer is simply the passage of time: you can't expect revolutionary fervor to last for 70 years. But perhaps also the unexpected resurgence of capitalism played a role. By the 1980s Russia's elite was all too aware that the country, instead of overtaking the capitalist nations, was slipping behind - that Russia was failing to take advantage of new technology, that if anyone was challenging the West it was the rising nations of Asia. Communism lost any claim to the mandate of history well before it actually fell apart, and perhaps that is why it fell apart.

In the end, then, capitalism triumphed because it is a system that is robust to cynicism, that assumes that each man is out for himself. For much of the past century and a half men have dreamed of something better, of an economy that drew on man's better nature. But dreams, it turns out, can't keep a system going over the long term; selfishness can.

Financial Engineering

Emanuel Derman provides his lecture notes on financial engineering.

The price of popcorn

Mark Thoma points to some researh that supports the idea that the high cost of popcorn at cinema is a way to price discriminate and attract more people to the movies. While the "concessons" account for just 20% of revenue, they account for 40% or profit. Without this, ticket prices are higher and less people see films.

Currency managers

Do Professional Currency Managers Beat the Benchmark?

Momtchil Pojarliev and Richard M. Levich look at the performance of currency managers and compare their returns to some basic trading strategies: carry trade; trend following; relative value and volatility. They find that most returns are the equivalent of beta as being earned by making simple strategies. However, there are a small sub-set that make alpha and this appears to be a persistent group.

The Great Moderation

Mark Thoma points us to a conference on the "Great Moderation".

Comin and Mulani also examine the effects of technological change on economic growth and volatility and, similarly, find that technological change leads to both faster growth and lower volatility. But in contrast to the previous paper, Comin and Mulani argue that this good result holds only for the national, or macro, measures. Indeed, predictions from their model suggest that firm-level, or micro, volatility should increase as the pace of technological innovation increases. To get this result, they consider an economy with two types of technologies: general innovations (GIs), which are not patentable and are used by all firms in the economy, and research and development innovations (RDI), which are patentable and used by a limited number of firms. They then assume that GIs are produced by large, stable firms and RDIs are produced by smaller, more volatile firms. Under these conditions, they show that increases in RDIs (for example, due to government research and development (R&D) subsidies) lead to market "shake-up," whereby smaller firms gain market share and perhaps even leapfrog ahead of the previous market leaders. Since GI activity relies on the presence of stable market leaders, this shake-up creates both firm-level volatility and lower GI activity. The decline in GIs, which by definition help all firms, reduces the comovement between firms in the economy, ultimately reducing the volatility of aggregate outcomes. Said more simply, if the increase in the innovative activity comes from small firms jockeying for position in the industry, aggregate volatility will go down, as winners and losers will offset each other, but microvolatility will rise, as losing firms compete to get back on top. Comin and Mulani provide empirical evidence showing that increased R&D activity in the U.S. has coincided with increased volatility in sales and market shares for publicly traded firms, reduced comovement across industries, and reduced volatility in aggregate economic growth.

Coincides with UK experience, an increase of internal volatility has been aligned with a fall in the overall shocks. However, the internal shocks are painful and they are the thing that make people say that risk has been shifted to the household from the firm. That's okay if you own the firm, but it is unlikely that those that have taken on this risk have been compensated

Group think and low returns

Yves Smith and the Epicurean Dealmaker: point the finger at money managers and suggest that it was their greed and "group think" that cause the current financial mess. The desperation for higher returns brings us back to the low rates on offer. Not just the result of Greenspan at the short end but also the Chinese monetary authority and others further down the curve.

"Yves Smith does get something right. There was group think leading up to the current crisis, all right, just not among the investment bankers:
Kay's observation has some merit, but I think it applies more to the money managers and other investors who bought dubious paper more than it does to the perps.2 They were surrounded by peers who were buying complicated new products that offered higher returns; being skeptical suggested one was a Luddite, or worse, not up to snuff analytically (not that anyone did much analysis, as we have now learned).
It was not for the investment bankers to tell their customers that they were wrong to want higher return and lower risk, even if the two could not be separated. It was their job to try and provide those things, because that's what the customers paid them for."

Rotten English

Rotten English highlights the way that regional and non-standard English has oobtained increased importance and goes against the idea that things are more homogenous.

What would once have been pejoratively termed “dialect literature” has recently and decisively come into its own. Half of the novels that won the Man Booker prize over the past twelve years are in a non-standard English: the British Commonwealth’s most prestigious award honors passages like “It ain’t like your regular sort of day” (the opening line of Graham Swift’s Last Orders) and “What kind of fucken life is this?” (the persistent refrain of DBC Pierre’s Vernon God Little). The reading public has been just as approving, eagerly devouring works like Alice Walker’s The Color Purple and Junot Díaz’s Drown. Many vernacular novels, Walker’s own as well as Roddy Doyle’s The Commitments, Irvine Welsh’s Trainspotting and Alan Duff’s Once Were Warriors, have become acclaimed movies. This success is by no means limited to fiction; vernacular poetry has flourished in venues like the Nuyorican Poets Café and HBO’s Def Poetry Jam. The aim of this collection is to represent that literary florescence, along with the earlier works that anticipated and enabled it. Rotten English celebrates the stunningly unanticipated ways in which English has changed as it grew into a global language.

Clearing trades

The DoJ is pushing for a seperation of trading and clearing. The FT explains why this is important.
FT.com Futures reform:

"When an exchange controls clearing, it can prevent a customer from buying a contract on one exchange and selling it on another. Customers, therefore, have everything to gain from the DoJ’s move. The US stock markets, where exchanges share a common clearer, are undergoing fierce competition that has seen tariffs slashed, spreads tightened and volumes soar."

Watch the fees

Bloomberg.com

A look at the US school districts that were drawn into swap agreements. The attraction of money up front for risk in the future suggests some behavioural biases. The fact that Bloomberg is attacking banks for excess sugggests that the time is up for large scale bank profits.

Frozen

Capital flow

Pepys Diary The Deputy-Master of the Mint on capital flow:

To another question of mine he made me fully understand that the old law of prohibiting bullion to be exported, is, and ever was a folly and an injury, rather than good. Arguing thus, that if the exportations exceed importations, then the balance must be brought home in money, which, when our merchants know cannot be carried out again, they will forbear to bring home in money, but let it lie abroad for trade, or keepe in foreign banks: or if our importations exceed our exportations, then, to keepe credit, the merchants will and must find ways of carrying out money by stealth, which is a most easy thing to do, and is every where done; and therefore the law against it signifies nothing in the world. Besides, that it is seen, that where money is free, there is great plenty; where it is restrained, as here, there is a great want, as in Spayne. These and many other fine discourses I had from him

Lease or own?

FT
On the advantage that hotel chains have when they lease rather than own.

"The property-light model has lower fixed costs, permits rapid expansion and provides some cushion against the cycle because franchisees pay a fixed service fee in addition to a share of room revenues. UBS estimates that a 1 per cent drop in average room rates for a notional operator with fully owned hotels would knock 6 per cent of pre-tax earnings. A fully franchised operator would see profits drop by just 1 per cent."

Happiness

Kahneman talks about changing his mind.

To compound the irony, recent findings from the Gallup World Poll raise doubts about the puzzle itself. The most dramatic result is that when the entire range of human living standards is considered, the effects of income on a measure of life satisfaction (the "ladder of life") are not small at all. We had thought income effects are small because we were looking within countries. The GDP differences between countries are enormous, and highly predictive of differences in life satisfaction. In a sample of over 130,000 people from 126 countries, the correlation between the life satisfaction of individuals and the GDP of the country in which they live was over .40 – an exceptionally high value in social science. Humans everywhere, from Norway to Sierra Leone, apparently evaluate their life by a common standard of material prosperity, which changes as GDP increases. The implied conclusion, that citizens of different countries do not adapt to their level of prosperity, flies against everything we thought we knew ten years ago. We have been wrong and now we know it. I suppose this means that there is a science of well-being, even if we are not doing it very well.

Food, glorious food

There was something uncomfortable about watching Fearnley-Whittingstall, a gentleman farmer, trying to guilt-trip people on low incomes over what they eat. There's no doubting his commitment. And yes, in an ideal world, we would all eat locally sourced meat raised in the most glorious of conditions. Millions of people with the available cash spend their extra money to ensure they do just that. I am one of them. I am willing to spend a significant proportion of my income on ingredients, because I am a greedy man who has the luxury of being able to support an overly developed interest in his dinner.

But there are much bigger issues at play here and to understand them we need to take the long view. The reality is that the downside to human health from the factory farming of chicken - a certain amount of salmonella and campylobacter, both of which can be eliminated by proper handling in the kitchen - are vastly outweighed by the upside. However much the animal welfare lobby may disagree, it is arguable that the upside also outweighs the significant negatives for those intensively reared chickens.

'Prior to the 1950s, large numbers of people died because of tuberculosis due to a simple lack of nourishment,' says Hugh Pennington, emeritus professor of bacteriology at Aberdeen University and an expert on food contamination and nutritional issues. 'The wide availability of cheap animal proteins, both chicken and fish, has put an end to that.' The availability of those intensively reared chickens that go from egg to slaughter in just 39 days without ever seeing daylight is, therefore, not merely a question of taste to be pursued doggedly by a lovable TV chef. It's a question of basic human health.

Jay Rayner

RMB appreciation

RMB has apreciated an annualised 20% in the last month. It looks as if there may be a change in policy from the Chinese authorities. The big question is whether this pace of appreciation will be maintained or whether there will be a conclusive revaluation to a higher level. The problem with the current strategy is that it will only increase speculative flow into the RMB and may make the job of the Chinese monetary authorities even more difficult. The picture and the information comes from Macro Man.

CDO

Felix Salmon overview of CDO creation with over-collateralisation.

But what happened over the past few years was that demand for those AAA-rated CDO tranches went through the roof, and it became harder and harder to find a nice diverse universe of BBB-rated bonds to throw into the cauldron. As a result, the ingredients getting thrown into the cauldron started getting less and less diverse, until it reached the point that all, or nearly all, of them were, in some way or another, ultimately reliant on subprime mortgage payments.

Risk and liquidity

FT.com
looks at the way the the move away from risk has affected liquidity in markets like the US treasuries and European bonds.

"Indeed, even in the US Treasury market, the spread between buy and sell prices for securities issued by the Treasury before the current quarter has become a lot wider than normal. “Traders and banks are in risk-reduction mode,” said Tom di Galoma, head of Treasury trading at Jefferies."

There is a higher price to pay and a wider spread.

Chinese Reserves

FT.com looks at the slowing pace of Chinese reserves.

"However, the monthly increase represented the smallest rise since September 2006. Indeed, after rising at between $40bn and $50bn per month in the first seven months of this year, Chinese foreign exchange reserves rose by just $23bn in August and $24bn in September"

The Chinese continue to print yuan and exchange it for US dollars. It is a step forward that the Chinese are developing a diversified portfolio. However, it does not remove the impression that their saving is too high.

Mercurial

Mercurial from the latin mercurious

Mercurial comes from Latin Mercurius, "Mercury," the Roman god of commerce and messenger of the gods.

A reminder of the flexibility or signalling quality.

USD weakness

MacroMan

EADS announced Q3 "earnings" today, wherein they reported a loss of "only" €776 million, better than the expected €1.15 billion loss. But the insight on currency hedging is instructive; through the first 9 months of the year, EADS saw $11.8 billion worth of hedges mature: th4e average rate was 1.14 EUR/USD. In their stead, EADS has placed fresh hedges totally $15.1 billion, with an average rate of 1.37. That is a material change in competitiveness that is no doubt being mirrored elsewhere in Europe (or at least France); why else would Nicolas Sarkozy warn the US Congress that dollar weakness could lead to "economic war"?
Speaking of the US Congress, the Joint Economic Committee welcomes Ben Bernanke to the dance floor today for testimony on the US economic outlook. We can expect him to be peppered with queries on subprime, housinng, and the banking system, and perhaps also the level of the dollar. Yesterday's barrage of Fed speakers made it pretty clear that they are comfortable with where rates are as things currently stand, though we should probably expect BB to note that the Fed stands ready to act should conditions deteriorate markedly from here.

What's interesting is that several of yesterday's speakers also mentioned the level of the dollar, a topic that has been absent from their comments for the past several years. Could we perhaps be morphing towards a May 2006 scenario, wherein the Fed belatedly realizes that they are suffering from a credibility deficit and decides to "talk tough" to restore the balance, even in the face of crumbling risky asset prices?.

Investment responses to prices

FT's Lex talks about a change in strategy at BT in response to evidence that oil prices will be higher than they had forecast.

If deals and capital spending follow, it would represent a U-turn by BP. It is also understandable why oil majors use cautious long term forecasts. Nonetheless with spot oil prices now almost four times BP’s current planning assumption, it looks likely that Mr Hayward will turn the capex tap on.

Free Exchange on a story that has been circulating.

When Bundchen, 27, signed a contract in August to represent Pantene hair products for Cincinnati-based Procter & Gamble Co., she demanded payment in euros, according to Veja, Brazil's biggest weekly magazine. She'll also get euros for the deal she reached last October with Dolce & Gabbana SpA in Milan to promote the Italian designer's new fragrance, The One, Veja reported. Bundchen earned $33 million in the year through June, Forbes reported in July.

Crack

The FT on the problems with the spread between retail and crude oil that cost ExxonMobile in the latest quarter.

Declines within Exxon’s refining and marketing business were no surprise. The entire sector has taken a hit, with third quarter refining earnings generally down by half as compared with a year ago and margins down as much as 90 per cent from May highs. Exxon’s malaise was less severe than most, with refining profits down 30 percent. But the company’s shares slipped 2.7 per cent on concerns over its weak exploration and production volumes. Exxon’s upstream business is generally a strength, but the volatility of its profits there is bound to increase as price-sensitive gasoline becomes a bigger proportion of its production.

Macro Man supplies the picture and an analysis that suggests that the retail price of petrol will soon follow the crude price sharply higher.

Housing and consumption

Willem Buiter looks at the effect of housing on consumption. Amidst it all

Likewise, some current home owners may be planning to ‘trade down’ later in life, for instance when the family home gets replaced by a smaller property when the children leave home, following retirement or following the death of one’s spouse. For them the fundamental value of their endowment exceeds the present discounted value of their current and future planned consumption of housing services. Against that, there are also persons planning to trade up in the housing market.

This is probably a most important point. Given the number of people that seem to regard their property as their pension. There is an implicit belief that there will eventually be a mass trading down. Presumably, this will concertina the gap between family and smaller homes.

The other important point is

The argument for an effect of housing wealth on consumption over and above the pure wealth effect, is that housing wealth is collateralisable. Households-consumers can borrow against the equity in their homes and use this to finance consumption. If they are otherwise liquidity-constrained or credit-constrained, a boost to housing wealth would boost consumption by more than the pure wealth effect.

Buiter plays down this effect. However, outside credit cards, which are notoriously expensive, this is the cheapest and easiest way for the average person to access credit and liquidity. A rise in house prices provides a significant increase in the abililty to borrow, particuarly if, as is usually the case, it corresponds to an increase willingness on the side of financial instutions to offer credit.

Mifid

The FT has a good coverage of Mifid.

1987 Crash

From the WSJ

Mechanism design

Here is Alex Tabarrok on mechanism design.

Evan Davis on the same issue.

Al Roth on Mechanism Design.

Here is another overview which looks at the issue of market failure more generally.

Imperfect Knowledge

John Kay, marvulous as usual, on information and knowledge.

A new book* by Roman Frydman and Michael Goldberg coins the phrase “imperfect knowledge economics” to describe this world of fundamental uncertainty. They use the systematic failure of attempts to analyse exchange rate swings to illustrate the hopelessness of a search for economic explanations that transcend time and place. Frequent discontinuities and transitions in the ways market participants view events mean that economic models, like historical narratives, are context specific. The search for “sharp prediction” – the mantra of the modern scientific economist who seeks to replicate the successes of physics for social science – is doomed to failure.

This seems to be at the heart of exchanges rates. They move to a different tune at different times. The model changes over time. Maybe that is why technical analysis is so prevalent: there is a search for pattern. It suggests that any modelling must try to find the trigger that switches from one model to another.

Interest rates and risk-taking

Vasso P. Ioannidou and others look at the relationship between the level of short term interest rates and the amount of risk that a bank is prepared to take using a natural experiment in Bolivia (where the economy is dollarised and therfore monetary policy is set outside). They find that banks take more risk when interest rates are low: lending standards decline and ex-post default rates rise. However, banks do not charge more for the increased risk.

Sharia law and interest

Willem Buiter looks at the creation of financial products that are consistent with Sharia law amidst a more wide-ranging defence of debt.

The explosion of wealth, much of it held in financial form, among oil- and gas-exporting nations, many of which adhere, at least notionally, to fundamentalist-literalist forms of Islam, has led to an explosion of financial engineering aimed at circumventing the Quranic ban on riba. Considerable ingenuity and vast amounts of resources are devoted to the construction of financial products that are economically equivalent to interest-bearing loans or interest-bearing bonds, but theologically equivalent to permissible Islamic risk-sharing instruments. The process of certifying financial products as Sharia-compliant is time-consuming and costly; those with the religious authority to provide the desired certification (typically Islamic scholar-jurists) often don’t understand finance. Financial experts tend not to be well-versed in Sharia law and its application to financial structures. Those with the power of certification can extract significant rents from the issuers and buyers of Sharia-compliant problems.

Banking problems

Willem Buiter gives a great overview of recent problems in the banking industry.

Daniel Gross on the distribution of CDOs.

Price discrimination?

If people are generally honest,this may be perfect price discrimination.

Changes in China

Michael Pettis on the 17th Chinese National Peoples' Congress

If either of Bo (Xilai - current trade minister) or Zhou (Xiaochuan - Governor of the Peoples' Bank of China) are promoted onto the Standing Committee, I think we may end up seeing smarter and more preemptive activity in dealing with China’s monetary imbalance. If inflation figures for September and October stay above 5% or even accelerate I think we may see an acceleration of RMB appreciation even earlier than expected. This is all speculation, but like a lot of people in China I will be following the NPC rumor mill very closely.

Before the invention of Northern Rock

Tuesday 27 September 1664 (Pepys' Diary):

"Piggot came to see me, and desire my going down to Brampton Court, where for Piggot’s sake, for whom it is necessary, I should go, I would be glad to go, and will, contrary to my purpose, endeavour it, but having now almost 1000l., if not above, in my house, I know not what to do with it, and that will trouble my mind to leave in the house, and I not at home."

This is about £100,000 in today's money according to this site.

FSA slams the stable door shut

FSA launches scrutiny of bank liquidity - FT

LIBOR

Gillian Tett provides a good overview of LIBOR and some of the questions that have been raised recently about its use. Quotes no longer appear firm and the largest banks seek other forms of liquidity. The main quesion is whether this will continue when current conditions stabilise.

Liquidity

Fed Governor Kevin Warsh discusses liquidity and its relationship to confidence.

Northern Rock

The FT looks at the problems that remain at Northern Rock.

The biggest hurdle facing any potential bidder is the cost of Northern Rock’s balance sheet. At the end of June, the bank’s balance sheet stood at £113.5bn, about £80bn of which was funded through the capital markets. Not all of this is due immediately: Northern Rock has almost £46bn tied up in mortgage-backed securities, which should be unaffected by the bank’s travails.

Even so, any institution looking to take over Northern Rock would still have to be highly confident that it could raise more than £30bn in financing in the short term. In the current environment, even some of the world’s largest banks consider this a stretch.

But raising the necessary financing would only be the first step. The cost of borrowing is also crucial. According to analysts at Citigroup, Northern Rock’s assets generate a return of slightly more than 6 per cent. That is less than the current cost of borrowing in the three-month interbank markets. In other words, any institution that took on Northern Rock’s balance sheet and financed it through the short-term money markets would currently be making a loss.

There are further complications. The immediate panic among customers has abated, but savers are likely to remain wary of Northern Rock for some time. This means the deposit base, which has already fallen by £3bn, is likely to shrink further. Northern Rock has also revealed investments in debt securities, including structured investment vehicles and collateralised debt obligations, which will have to be written down.

The Guardian raises some questions by the shareholders for those in charge.

He emphasised the board was "well aware" of its responsibility to its many shareholders, "including tens of thousands of small shareholders", and its largest shareholder, the charitable Northern Rock Foundation, to which it gives 5% of pre-tax profits to support good causes.

However, the bank has yet to explain why it refrained from informing the stock market of a deterioration in its finances in the middle of August. The governor of the Bank of England, Mervyn King, told the Treasury select committee last week that he was alerted to an impending crisis on August 14.

The shareholder group said it wanted to know why an announcement was delayed until the rescue package was finalised on September 14.

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The group and the individual

NYT looks at the evolution of behaviour that supports group cohesion. Those societies that had strong group ties (either through religion or other norms) probably had better chance of survival than those that did not. However, there is an argument that suggests that indivudlalism now is more condusive to innovation.

Reintermediation

The Global Liquidity Blog points to a couple of references to the reintermediation that is expandinng banks' balance sheets. This is helping to encourage the demand for liquidity and could also lead to a desire to increase capital.

Bank Run 2

The BBC on the Northern Rock depositors trying to withdraw funds.

"The Chancellor says 'don't panic' but that's what the captain on the Titanic said, and that went down"

SIVs

Excellent overview by Mark Thoma of the role of SIVs in the current liquidity crisis.

TIC data

Just a note to remember that the TIC data do not fully represent UK financial flow.

From Brad Setser

Some of the flows from Europe are pretty easy to explain. Most of the UK’s purchases of Treasuries, for example, seem to be bought by institutions that are either acting for the world’s central bank or doing a roaring business buying US treasuries when the US market is open and selling those Treasuries to China (and others) when their markets are open. Every year the survey revises the UK’s holdings of Treasuries down by something like $100b, and revises the holdings of China and others up. Much the same process likely happens with Agencies, though in that market, Russia could be almost as important as China.

The demand for money

The FT looks at the difficulties in the money market as banks hoard cash and scramble for additional liquidity. This puts another perspective on the debate conducted by William Polley about the optimal amount of cash to hold.

The demand for liquidity is not constant and the cost of iliquidity can increase dramatically at times.

Financing the US deficit

The FT reports on the increased appetite for US acquisitions amongst Asian entities. This should help to mitigate the slide in the US unit that Barry Eichengreen talks about today.

Limits to arbitrage

Good to look again at Schliefer and Vishney, The Limits of Arbitrage and Keynes' "Markets can remain irrational longer than you can remain solvent",
The context?

Brad DeLong with the coverage of John Meriwether's LTCM call for more money.

More on barriers to bottom fishing from Felix Salmon.

The operation of the UK money market

The FT has a good overview of the operation of the UK money market and its interaction with the central bank amidst a story about a 'misunderstanding' between Barclays and HSBC.

The Marshall Plan

Naill Ferguson on Greg Behrman's 'The Most Noble Adventure'.

The total aid package was equivalent to less than three per cent of the recipient countries’ combined national income, and it represented less than a fifth of their gross investment.

To gauge the true importance of the Marshall Plan, it is crucial to get a sense of the amounts involved. Behrman writes, “From June 1947 to its termination at the end of 1951, the Marshall Plan provided approximately $13 billion to finance the recovery . . . of Western Europe.” This was less than half the Europeans’ initial request and four billion dollars less than President Truman’s initial proposal to Congress, but it was still serious money. Behrman computes that, in today’s dollars, “that sum equals roughly $100 billion, and as a comparable share of U.S. Gross National Product it would be in excess of $500 billion.” That’s actually an understatement. In fact, the total amount disbursed under the Marshall Plan was equivalent to roughly 5.4 per cent of U.S. gross national product in the year of Marshall’s speech, or 1.1 per cent spread over the whole period of the program, which, technically, dated from April, 1948, when the Foreign Assistance Act was passed, to June, 1952, when the last payment was made. A Marshall Plan announced today would therefore be worth closer to seven hundred and forty billion dollars. If there had been a Marshall Plan between 2003 and 2007, it would have cost five hundred and fifty billion. By comparison, actual foreign economic aid under the Bush Administration between 2001 and 2006 totalled less than one hundred and fifty billion, an average of less than 0.2 per cent of G.D.P.

Financial Engineering

Brad Stetser with an overview of the comments on financial engineering. This emphasises the uncertainty and the lack of liquidity that is affecting the market. It also highlights the importance of the Fed change to provide confidence that some funds, without access to the discount window, can use banks to push illiquid collateral through to the Fed in exchange for cash.

Bank run

The bank run from "Its a Wonderful Life".



Thanks to Paul Krugman for the reminder.

The discount window

The FT has a story about how the Fed accompanied the cut in the discount rate with a reassurance to financial institutions that, other than the penalty rate, it would not discriminate against institutions that used the window. This certainly seems to be a change from the traditional position that would, it was suggested, mean additional scrutiny of banks that were frequent visitors to the window.

Squeezing the regulatory balloon

Charles Wyplosz has a nice overview on the way that risk has been pushed out of the banking system into other sectors of the financial system. The problem is not so large, particularly in relation to the overall size of the system, but it is not clear where the risk now lies.

The meaning of liquidity

The Lex column today looks at the relative health of the IPO market, with VMware's stock rising strongly on its first day. This suggests that there is money available for firms. There is some "liquidity" in a broad sense, but there is no "liquidity" in the credit markets. The first use of the term is more associated with money and its availability. Central banks that peg their currencies still have funds to park and these will continue to flow. However, the second meaning of the term means that the market is not functioning in certain sectors. The weaker players have to be shaken out before any kind of normality returns. The FT notes today that the commercial paper market is also affected. The situation is similar to the caution and fear that was in the equity market when people were looking for another Enron or Worldcom.

Who are the noise-traders?

John Campbell "who are the noise traders?" Thanks to Mark Thoma

Using the estimated relation between trades of different sizes and institutional ownership, Ramadorai, Schwartz, and I construct daily institutional flows in individual stocks and find that they have several interesting characteristics. Daily institutional trades are highly persistent and respond positively to recent daily returns but negatively to longer-term past daily returns. Institutional trades, particularly sales, generate short-term losses but longer-term profits. One source of these profits is that institutions anticipate both earnings surprises and post-earnings-announcement drift (the tendency for stock prices to continue moving in the same direction after an earnings surprise).

These results suggest that institutional investors do exploit certain well-known patterns in stock returns, but in doing so they trade urgently and move prices against themselves, causing prices to rise temporarily when they buy and, even more noticeably, to fall temporarily when they sell. As prices return to normal a day or two after institutional trading, institutions appear to make losses but in the longer run they earn profits from their abilities to pick stocks.

Be careful what you wish for....(2)

One thing that is often forgotten amongst the discussion of whether the EUR will take the USD role as the world's reserve currency is that the Bundesbank fought for years to prevent the D-mark taking on that role. The concern at the German central bank was that this could force them to draw their attention away from domestic price stability. Indeed, they had a good taste of that with the D-mark's role in the ERM with, notably, Norman Lamont famously haranguing Helmut Schlesinger in Bath for lower rates. In 1998 the Fed cut rates not just for the US economy but also to provide financial stability globally. Today the WSJ makes the point that the ability of the Bank of England to stand back and allow short term interest rates to rise owns something to the pound not being a reserve currency. It may also be related to the way the UK money market has an automatic penalty window that puts a 75bp cap on overnight rates. More on that here and here.

On the nail

Liquidity

James Hamilton on the loss of liquidity and the Fed's reaction to it. It is astonishing that the injection was as large as that provided 9/11.

Development

Interesting input on Greg Clark's assetion that the industrial revolution is a result genetic rather than institutional change. I particulary like the assertion that the decline in real interest rates is a reflection of a more cautious and less hedonistic nature. Of course, there is a dispute that the higher the interest rate, the more interesting you are!

Brad DeLongtakes it up.

West Ham vs Hull

My wife's from Hull.

I could not resist

Too big to fail

Willem Buiter discusses the bailing out of LTCM and IKB.

Feeding the demand for AAA credit

Flexi Salmon explains the way that AAA credit is created when there is a scarcity pushing prices up above the cost of putting together the pieces.

Quotations

Thanks to Barry Ritholtz at The Big Picture


"Markets can remain irrational longer than you can remain solvent."
— John Maynard Keynes

"The only thing that can console one for being poor is extravagance."
— Oscar Wilde

"It is pretty hard to tell what does bring happiness; poverty and wealth have both failed."
— Kin Hubbard

"The key to making money in stocks is not to get scared out of them."
— Peter Lynch

"If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem."
— JP Getty

"You try to be greedy when others are fearful, and fearful when others are greedy."
— Warren Buffett

"A cynic is a man who knows the price of everything, and the value of nothing."
— Oscar Wilde

"Do you know the only thing that gives me pleasure? It is to see my dividends coming in."
— John D. Rockefeller

"A gold miner is a liar standing beside a hole in the ground."
— Mark Twain

"There was a time when a fool and his money were soon parted, but now it happens to everybody."
— Adlai Stevenson

"It is generally agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges."
— John Maynard Keynes

"The safe way to double your money is to fold it over once and put it in your pocket. "
— Frank Hubbard

"Save a little money each month and at the end of the year you'll be surprised at how little you have."
— Ernest Haskins

Monopsony?

Friday 27 May 1664 (Pepys' Diary):

"This morning my taylor brought me a very tall mayde to be my cook-mayde; she asked 5l., but my wife offered her but 3l. 10s. — whether she will take it or no I know not till to-morrow, but I am afeard she will be over high for us, she having last been a chamber mayde, and holds up her head, as my little girle Su observed"

Reserves and liquidity

Brad Setser identifies one of the links between Asia and energy-producing central bank FX intervention and the supply of funds to financial markets. The BIS (table 5c) show a $53.5bn repayment by central banks of borrowing from private banks. Of course, this opens the way for lending to other institutions, like private equity firms.

Manufacturing or service sector

Inside a much longer item about The quiet rebirth of the manufacturer: Jonathan Guthrie talks about the blurred line between manufacturing and service sector industries.

"In time, the negative connotations of the word “manufacturing” may simply be bypassed because the term itself is obsolete. Rolls-Royce, for example, is these days primarily a service business that happens to make some rather good jet engines. At the other end of the size scale, Powerlase, a West Sussex business I visited on Monday, designs and markets high-tech laser systems. Which, incidentally, it builds itself."

Credit and private equity

Maybe I am wrong already - some evidence here that the Chrysler and Boots deals may be facing indigestion and that banks will be less keen to providing financing deals in the future now that they are less certain about unloading this in some sort of package to others.

The big uncertainty remains Asian and energy-producing central banks. Will then step up to purchase these assets at higher yields?

Credit outlook

Evaporation of liquidity in the CDO market is becoming more evident. The risk now is that this starts to affect the financing of other projects.

Concerns about the credit markets were exacerbated by a JPMorgan report that said sales of collateralised debt obligations – complex debt instruments that have helped fuel the global credit boom – have plummeted from $50.6bn in June. As of July 20, there had been $19.9bn in sales of CDOs, which pool loans and bonds into securities. Since then there have been no new deals. The diminishing demand for CDOs is raising fears that banks will be left with debt that has been used to finance leveraged buy-outs, affecting their appetite for future deals.

It is not clear if this just takes some of the steam out of the private equity market or becomes a more pronounced drying up of credit. Given the flow of finance from central banks in Asia and energy-producing countries, the softer landing still seems the more likely for now.

Tony Dye

I finally found something from Motley Fool on Tony Dye.

This is the article that announces his departure from Phillips and Drew. Here, before the benefit of hindsight, we have an idea of the loneliness of standing out from the crowd of "noise-traders".

Mr Dye's supporters say that he will eventually be proved right. In fact, they've been saying it for so long that it has become a bit of a cracked record. In any event, it would require one hell of a crash now to prove him right. Even if that occurred, I bet he wouldn't take the opportunity for a belated entry to the technological band wagon and it would be everyone else's turn to explain how they will end up being right.

There is also an interview with Tony Dye one year later.

Diversity and productivity

From Science
An unexplained combination of diversity and productivity that echoes New York and London and many others.....

This is an important paper because it demonstrates genetic diversity can lead to a marked increase in performance," says entomologist and neuroscientist Gene Robinson of the University of Illinois, Urbana-Champaign. Previous studies of the impact of diversity on hive function had yielded inconsistent results, he notes, but the new one is the longest and most comprehensive. It's not clear why diverse hives would be more productive, but one theory is that the bees are more sensitive to work-related stimuli and thus more likely to take on various tasks. As for the reported disappearance of honey bees and collapses of hives (Science, 18 May, p. 970), Robinson says that lack of diversity isn't thought to be a cause. The queens in most commercial beekeeping operations are mated with multiple drones.

Core vs headline

John Berry at Bloomberg

In a commentary sent to Citigroup's clients July 13, economist Robert V. DiClemente at Citigroup Global Markets Inc. called the issue of overall or ``headline'' inflation versus core inflation ``a false debate.''

``The Fed's commitment to price stability does not entail choosing one over the other,'' he said. ``History has demonstrated that so-called core measures are a good guide to headline inflation's ultimate path.''

DiClemente noted that from 1984 until 2005, the cumulative increase in core prices was consistently a bit greater than that in overall prices. Then the surge in energy prices tipped the balance the other way.

In the short run, the overall measures are much more volatile. ``Policy that responded to such short-run deviations in overall prices would not only put the economy on a roller coaster, it would risk distorting important relative price signals, possibly undermining economic efficiency and policy's own credibility,'' he said.

The old same story. It is not about the level of prices, it is about the rate of increase in prices; not the cost of living, but the change in the cost of living. There are problems with the traditional core because food and energy have been particularly buoyant recently. However, the subdued nature of the core rate suggests that these increases have not YET fed back into other prices. The timmed-mean core measure is probably better
More here.

Rumours in the insurance market

Tuesday 19 April 1664 (Pepys' Diary):

"‘Change full of news from Guinny, some say the Dutch have sunk our ships and taken our fort, and others say we have done the same to them. But I find by our merchants that something is done, but is yet a secret among them."

From CDOs to CDS

The problems in the CDO market are now having an impact on the cost of insuring against default. The FT reports that the financial institutions with a number of different links to the CDO market have been hardest hit.

Along with other areas of the CDS markets, these groups recovered some ground on Thursday, but BoA for instance was still trading at a spread of about 20 basis points – which means it costs $20,000 annually to insure $10m worth of its debt over five years. This is up by about one-third since the start of the week.

BoA has direct lending home owners, a business in packaging CDOs and holdings of CDO products. Other financial institutions have less exposure.

Credit tightening

A couple of stories in the FT point towards some tightening in the credit market. The first looks at a general tightening of credit condition while the second concentrates on the Spanish market. The spread of this caution could cause a moderation in business activity in the coming months. However, with abundant global liquidity this is not likley to be sufficient to affect the whole economy. More important will probably be the reaction of consumer spending in developed countries to the increase in domestic interest rtaes that is taking place.

Who holds CDOs?

The FT has a report on Citibank information on the owners of CDOs.

Similarly, I guessed that those buying the so-called “equity” tranches (which are wiped out first if the value of the underlying assets falls) would be hedge funds or investment banks.

Not so. Measured on a global basis, Citigroup’s data suggests that its hedge fund clients hold about 50 per cent of their CDO exposure in equity tranches. But, asset managers who are not classic hedge funds have more than 40 per cent of their CDO exposure in equity tranches too.

Indeed, these asset managers hold less than 20 per cent of their CDO exposure in the form of AAA-rated, senior tranches. And – most striking of all – that proportion of senior debt is actually lower than at hedge funds, insurance companies or banks. (Banks have a whopping 60 per cent of their CDO exposure in senior tranches, although this pattern varies sharply across regions.)

The law of one price

FT.com Arbitraging Chinese stocks:

"Can anyone exploit the $75bn arbitrage opportunity? Companies can. They could raise equity in Shanghai and use the proceeds to repurchase Hong Kong shares at a premium to their market price. Whether state-controlled companies are prepared to exploit so openly the appetite of mainlanders to overpay for equity is doubtful. But they are beginning to do something fairly similar by raising money in Shanghai to buy real assets, to which Hong Kong shareholders will have a pro-rata claim. PetroChina has just said it will raise $6bn. Others without Shanghai listings like CNOOC and China Mobile should pile in too. They will help prick a bubble and raise dirt cheap capital, which should keep the state and foreign investors happy respectively. Pity, though, China’s punters."

Road rage

Pepys Diary 1 February 1663/64

Here I hear how two men last night, justling for the wall about the New Exchange, did kill one another, each thrusting the other through; one of them of the King’s Chappell, one Cave, and the other a retayner of my Lord Generall Middleton’s.

There was an advantage to be next to the wall, out of the shit in the road and a little less exposed to chamber pots from the upper levels.

The song remains the same....

From the diary of Samuel Pepys Friday 11 December 1663.

"I to the Coffeehouse and there among others had good discourse with an Iron Merchant, who tells me the great evil of discouraging our natural manufacture of England in that commodity by suffering the Swede to bring in three times more than ever they did and our owne Ironworks be lost, as almost half of them, he says, are already."

Thanks Phil

Dark Liquidity

Changes to the buyers of fiancial products are encourging changes to market itself. The rise of hedge funds, algorithermic trading and the increase size of some traditional funds are putting pressure on exchanges to lower costs and reduce market impact.

FT.com: "Consolidation among fund management groups, for example, is giving the buyside pricing power it once did not have. Moreover, the rise of hedge funds and the advent of so-called algorithmic trading is altering the buy-side landscape. As demands from their own customers change, the banks must change with them."

Cutomer focus pays

Thanks to The Big Picture for the paper showing that firms with the highest customer satisfaction also out-perform the market.

Carbon Emmision

More efficient, more dynamic and less carbon.

London

The buck stops....

People keep wondering where the risk lies with the packaging and passing of credit risk. this article in the FT points to Credit Derivative Product Companies (CDPC) as being anxious to get hold of the risk.

This nascent industry is still very small, with only four groups in operation. But this year could see a raft of new CDPCs hit the market, all hoping to take a slice of this credit derivatives business and make more of it than banks can.

More than a dozen hopeful firms are in the works, backed by a mixture of private equity, hedge fund and investment bank sponsors.

Inflation index

Mixing up a chagne in relative prices with inflation.

Wolfgang Munchau:

"The problem was that the official inflation index no longer reflected many people’s personal shopping basket. The index basket is full of manufactured goods largely produced in Asia, while we spend most of our money on services, such as childcare, education, healthcare, transportation, travel and gastronomy."

Insider trading

Some information on the latest activity in the options market compared to the norm.
Paul Kedrosky provides the link.

Nature or nurture

The purpose of the status system is to enable children to compete successfully with their peers. In order to do this, they must acquire self-knowledge. Children have to discover how they compare with other children along a variety of dimensions. Am I tall or short, strong or weak, pretty or plain, smart or dull? Without answers to these questions, they would have no way of deciding whether to try to dominate others or yield without a fight, to make suggestions or follow the suggestions of others, to turn down potential mates in hopes of doing better or take whatever comes along. Based on their understanding of their own strengths and weaknesses, of the options offered by their environment, and of the particular set of other children with whom they must compete, children work out their own individual strategy of behaviour. "I'm not good in maths," James (the boy whose mother is a poor disciplinarian) admits. But he's popular with his peers. Every child has to find out what he is good at and place his bets on the things that are most likely to pay off. Even identical twins will find different niches to occupy.

Prospect Magazine with a fascinating look at nature vs nurture.

PFI

There is a good overview of the PFI at the FT today.

The item calls overall for an assessment of the costs and benefits. The costs are clearly associated with the increased cost of borrowing and the fact that some projects are miscalculated so that the private sector makes huge profits. The benefits seem to come from the increased chance that projects will be completed on time and the transfer of risk to the private sector.

Commodity prices in Babylonia

Here is an amazing discussion of commodity prices in ancient Babylonia.

Increase in global labour supply

Martin Wolf: "First, by simply weighing each country’s labour force by the share of exports in total GDP, the authors conclude that the effective global labour supply quadrupled between 1980 and 2005, with half of the increase coming from east Asia. "

Behavioural finance

Why the Human Brain Is a Poor Judge of Risk -:

"And it's not just risks. People are not computers. We don't evaluate security trade-offs mathematically, by examining the relative probabilities of different events. Instead, we have shortcuts, rules of thumb, stereotypes and biases -- generally known as 'heuristics.' These heuristics affect how we think about risks, how we evaluate the probability of future events, how we consider costs, and how we make trade-offs. We have ways of generating close-to-optimal answers quickly with limited cognitive capabilities. Don Norman's wonderful essay, Being Analog, provides a great background for all this."

ABX.HE index

Cleveland Fed on the ABX.HE index:

"This is the ABX.HE index, which is based on credit default swaps on different tranches of subprime mortgage-backed securities (MBS). Admittedly, unless you’re a financial markets junky it’s not at all clear what this index is saying, other than something called BBB is moving a lot more than the stuff called AAA. Let’s try to deconstruct what’s going on, keeping in mind that this is most definitely not investment advice. "

Debt

Economist's view links to a story from the NY Times that looks at how debt has been stigmatised over time. It highlights a cycle of financial innovation, missuse and regulation that is apparent in the US mortgage market. The article suggests that the end result is that people are better off.

Sarkozy and the EUR

From Simon Derrick

French presidential candidate Nicolas Sarkozy says: "Competition is such with globalisation that we don't need to fight inflation like we fought inflation 30 years ago. I want the Europeans to be able to do with the EUR what the Americans do with the USD, the Japanese with the JPY and the Chinese with the CNY (i.e. use their powers to influence exchange rates). It's the very least." He adds: "We are depriving ourselves of an instrument to create growth, provide jobs, for purely ideological reasons. Well, the EUR doesn't belong to Trichet ... and I'm not the only one in Europe who thinks so."

Should make ECB job more difficult if EUR appreciates and core inflation rises to 2.0%.

Credit marke still in operation.

Freeport prices $6bn bond:

"The US debt markets absorbed the biggest junk bond deal for 18 years on Wednesday in spite of concerns about losses in the subprime mortgage market that have diminished investor appetite for risky debt.

Freeport-McMoRan Copper & Gold priced a $6bn deal to fund its acquisition of Phelps Dodge, a deal that will create the world’s largest publicly traded copper company. "

Sub-Prime

FT.com:
on the inevitable slowdown in the Residential Mortgage Backed Securities market. Of interest is the estimate of the effect on investment bank revenues. It does not actually seem that much.

"Brad Hintz, analyst at Sanford Bernstein, estimates that as investor appetite for CDOs grew, the RMBS business of major Wall Street firms ballooned to 15 per cent of total fixed income revenues. Subprime and Alt-A mortgages accounted for 25 per cent of RMBS total, he said."

Credit Derivatives and Bank Credit Supply--Federal Reserve Bank of New York

Credit Derivatives and Bank Credit Supply--Federal Reserve Bank of New York:

"We find evidence suggesting that greater use of credit derivatives is associated with greater supply of bank credit for large term loans—that is, newly negotiated loan extensions to large corporate borrowers—though not for (previously negotiated) commitment lending."

Credit Derivatives and Bank Credit Supply--Federal Reserve Bank of New York

Credit Derivatives and Bank Credit Supply--Federal Reserve Bank of New York:

"We find evidence suggesting that greater use of credit derivatives is associated with greater supply of bank credit for large term loans—that is, newly negotiated loan extensions to large corporate borrowers—though not for (previously negotiated) commitment lending."

The euro area repo market

The growth in the euro area repo market. Rising interest rates and the new BIS rules have allowed the market to develop.

FT.com :

"Repo traders also say that the rising interest rates in Europe over the past year have created more business because there is increasing scope to make money on the interest rate spread between European overnight banking rates and the repo rates set on the various securities used as collateral."

Who pays?

FT.com
looks at Citigroup data that suggests that hedge funds were selling higher yielding assets while pension funds were moving into this asset.

"Instead, the list of those nursing bruises may well turn out to include bank prop desks and pension funds. Not to mention those real money clients of Citigroup who had the bad judgment (or luck) to raise their positions in European credit last month."

Trough of creativity

As a counterwight to the stories about peak oil or peak energy, we get some insight into the potental innvoations that arise if energy become scarce and more expensive.

Thanks again to Paul Kedrosky with this story about the increased attempt to capture wasted energy.

Chinese Reserve Policy

From Simon Derrick, overview of the changes that may take place in China. There is continued pressure for diversification. However, if we move beyond asset classes, it remaisn difficult to remove questions of currency diversification from those of exchange rate peg.

The Bank of New York - Global Markets Website:

"The latest leaks out of Beijing suggest that the next step towards the formation of a new agency to manage the “surplus” portion of China is likely to be taken in the next few weeks. Market News International reported just over a week ago that next months meeting of the National People’s Congress (the nation’s top legislative body), is likely to approve plans to establish a new agency to help manage the reserves. This agency, under the control of the Ministry of Finance (and, reportedly, to be headed by Vice Minister Lou Jiwei), would be in be in charge of purchasing high-yield assets both at home and abroad including resources for China's economic growth and would report directly to the cabinet. A report in the Southern Weekly newspaper indicated that this “State Foreign Exchange Investment Corp” would manage in excess of USD 200 Bn and that the money could be spent on a wide array of domestic and international assets, from oil and gas to financial assets and entire companies. Another USD 100 Bn from the reserves would, reportedly, be allocated to Central Huijin (a division of SAFE).

The report today from Reuters (citing “sources close to the State Council”) that Vice Finance Minister Lou Jiwei is likely to replace Hu Xiaolian as chairman of Central SAFE Investment Ltd., suggests that this plan is well under way. With the report indicating that the cabinet has agreed in principal to the appointment of Lou as head of the new agency it seems the stage is set for announcement after the end of the congress. It also strongly suggests that the bureaucratic wrangling that reportedly had been taking place between the MOF and "

BIDS

The FT:
gives an overview of the BIDS system that will facilitate off exchange transactions. The technical problems that affected the NYSE on Tuesday can only add to the pressure to find alternatives.

"Earlier this week, the New York Stock Exchange introduced curbs on trading designed to ensure that the trading of large blocks of shares by specialist traders did not exacerbate market falls.
The BIDS system will offer users an efficient electronic trading platform to anonymously execute block trades and is expected to launch in spring.
“This level of industry support prior to our launch validates our model and helps build tremendous momentum in advance of the launch of the system,” said Mr Mahoney.
The system will be accessible to both buy-side and sell-side users that want to trade large blocks through continuous order matching and trade negotiation.
The company said the use of the BIDS system as a block trading service will not be exclusive or subject to volume commitment and each participant could continue to use any other automated trading system, electronic communication network or exchange service that supports the trading needs of its customer base."