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Monday, 11 May 2009

Edinburgh economist predicts toxic debt boon

From Sunday Times business section, 10 May, 2009, page 1
"Robert McDowell says UK Treasury will finance recapitalisations and pay off many budget deficits through troubled banks" by Ian Fraser
The UK government should comfortably claw back at least half of forecast budget deficits in 2010-12 because of higher-than-expected returns from its ownership of shares in troubled banks and profits from bank bailouts, according to an Edinburgh-based economist.
Robert McDowell, a banking economist and risk-management consultant, said: “The UK and US Treasuries are charging substantial fees and exerting 25-30% haircuts, leaving themselves with more than adequate headroom to generate substantial medium-term profit which, I calculate, will finance both their bank recapitalisations and pay off half of medium-term government budget deficits, thus relieving taxpayers of the risk of sharply higher future tax rates.”
The British and American Treasuries have been criticised for their programmes to purchase billions of pounds of “toxic” and“legacy assets” from the banks, including impaired mortgage-backed securities, collateralised debt obligations, credit card bonds and student loans.
However, McDowell, who advises governments as well as banks, said such criticism is unjustified. He believes that, while asset-backed securities were arguably the cause of the credit crunch, they are also going to play a part in bringing it to an end.
McDowell said the UK government’s support for the banking sector, including the special liquidity scheme and the asset protection scheme, will generate a net profit of about £185 billion, and possibly more than £200 billion, “which is a substantial three-year gain from off-budget financing worth about £900 billion currently”. He said £200 billion would eradicate 45% of future budget deficits.

To this I add: The 2009 Budget authorises the bank of England to engage in up to £150 billions in Quantitative Easing, which means buying in outstanding gilts (government bonds) early. No-one has questioned where the financing originates to buy back the gilts. It has to come from net balance between assets and liabilies on the Bank of England's balance sheet. last time I looked the BoE balance sheet was £500bn, considerably more than the IMF which is seeking to grow to that level and equivalent to that of the Bank of International Settlements. Not all of the nearly £600bn assets being bought in by the BoE have yet transacted and its quantitative easing programme is somewhere in the £25-50bn range so far. I view the £150bn authorisation as an indicator of the net profit medium term that the government expects roughly to generate from its investment in saving the banks including majority ownership under UKFI Ltd.
BoE said it would spend a further £50bn of newly-created money to buy bonds. Note that the ECB has so far expanded its balance sheet much less than the BoE despite being responsible for a much bigger eceonomic areas. It has pledged to buy €60bn (£53.4bn) of covered euro bonds though the size of its asset purchase scheme is still small in comparison to those operated by the Federal Reserve or BoE with HM Treasury. This is something of an indictment of the Euro Area system whereby all the money market liquidity windows of the 16 constitutent central banks are vested and centralised in the ECB. It has a board of 16 central banks' representatives plus 6 ECB'ocrats, but among the central bankers are 9 economists and this bodes well for its gathering responsiveness. ECB President Jean-Claude Trichet said the bank would buy covered bonds, typically backed by mortgages, but did not rule out other purchases, which may let the ECB buy government bonds, although this has by political convention about fairness been resisted so far. The ECB will double the maximum term of its loans to banks to 12 months and loosen the rules on the assets which can be used as collateral to lessen the financial strain throughout the eurozone. 12 months is however much shorter than the 3 years offered by the BoE and similar medium term support from the US Treasury and Federal Reserve.
Details of the Bank of England's Special Liquidity Scheme (21.4.08) and its successor Asset Protection Scheme and Asset Purchase facility (19.01.09) - both organised by BoE as 'agent for HM Treasury and the Debt Management Office) do not have to be revealed until October 2009, and at the government's discretion not even then. This is according to the 2009 Banking Act ( What we do know is the following asset swaps for treasury bills and Bank of England cheques, where the bank assets are securitised as asset banked bonds and purchased as collateral for up to three years for: SLS - £245bn assets pledged as collateral, swapped for £185bn in treasury bills, with a roughly 3% fee. The assets are securitised as bonds paying about 3% above LIBOR, averaging say 5% net after the coupon on the T-bills over 3 years = £6bn + £28bn.
The difference between the assets pledged and the T-bills they were swapped for provides backing for the £37bn of preference shares bought from Lloyds TSB, HBoS and RBS paying 9% (subject to the banks' profitability). We can assume they will pay and average of 6% over 3 years = £7bn.
The APS scheme has we know taken in £325bn and £245bn from RBS and LBG plus another £15bn in exchange for Bank of England cheques left as deposits with the Bank of England, for a £22.1bn fee paid partly in preference shares and converted into common stock, and 2% insurance, plus very importantly, the banks agree to make no tax claim for losses for "several years!" (see
It is not possible to gauge the exact value of all this, but investment in bank shares of £37bn plus £34.6bn (£71.6bn) and becoming worth more. (see p.59 of Budget Report
These shareholdings were paid for off-budget i.e. not at taxpayers' expense. This plus about £30bn a year on average over 3 years in coupons and dividends i.e. £150-200bn say over 3 years, but can become considerably more.
There is also the BoE's Asset Purchase Facility. "Following a request from the MPC, the Chancellor authorised the Bank of England to use the APF for monetary policy purposes and increased the total scale of the fund to £150 billion, up to £50 billion of which could be used for private sector asset purchases. Asset purchases since then have been financed by the issuance of central bank reserves at the Bank of England". (page 60, Budget Report)
'Central Bank Reserves' means BoE cheques as per the Asset Protection Scheme. This has the advantage that the recipients cannot sell the payment they receive and must keep this as a financial reserve. It avoid issuing treasury bills that could be sold and may be represented at unexpected times rather than simply rolled over.
Thus from these schemes the government should gain a net profit of about £185bn, and very possibly over £200bn, which is a substantial 3 year gain from off-budget financing worth about £900bn currently. If part or all of this is used in the Quantitative Easing scheme for buying in £75bn of government bonds and then up to £150bn in total, and I judge there could be another £50bn, this is about half of the government's likely Budget Deficit of £175bn deficit in 2009, then say £160bn and £125bn in 2010 and 2011 respectively.
Given that long term interbank funding that UK banks require to finance their funding gaps remains very hard to get from private sources, we can expect the Bank of England to add several £100bn more to the Asset Protection Scheme during the remainder of this year, which would mean we can be even more confident that there will be a £200bn three-year gain or more, sufficient to cover half of government budget deficits. The agreements with the banks will also ensure about £50bn in new lending into the economy by the banks.
Chancellor Darling in his Budget report 2009 highlights in red on p.25, "Reflecting the principle of transparency, the fiscal forecasts include a provisional estimate for the high end of a range for the net impact of unrealised losses on financial sector interventions, equal to 3½ per cent of GDP." The budget deficit is about 12.4% ratio to GDP for 2009/10, then 11.9% and 9.1% in the next two years. The Chancellor is therefore indicating that a substantial part the deficit is required, at least roughly half most probably,assuming a 4:1 multiplier, to compensate the economy for the banks' and possibly may not be needed if the government's financial sector interventions pay-off.
In the case of the ECB there is now tacit admission that the policy of leaving interest rates relatively high and quietly talking down the prospect of quantitative easing has been abandoned.
There remains considerable fear and uncertainty about how the chips will fall. The BoE's MPC recently stated: “The world economy remains in deep recession. Output has continued to contract and international trade has fallen precipitously. The global banking and financial system remains fragile despite further significant intervention by the authorities.”
The BoE's QE has prompted a sudden jump in the price of government bonds, or gilts. Though this may not be sufficient to close the gap so that the BoE will not still be buying the higher coupon outstanding gilts cheaply on the secondary market. It will no doubt use other banks to do the buying for it. we can see this in that despite the higher QE, the benchmark bond yield remains above the level it was before QE was announced and began.

Thursday, 7 May 2009


Bank stocks have been rising well internationally. Wednesday (yesterday) was especially good for US financial stocks as investors expressed relief the capital shortfalls identified by the government’s “stress tests” at large banks such as Citigroup and Bank of America were not as big as feared.
The bank rally occurred as news of the capital needs of the 19 banks involved in the tests leaked out during the day, ahead of the official release of the results on Thursday.
Citi, BofA and Morgan Stanley were among the big names that will have to raise equity following the completion of the tests, while JPMorgan Chase, Goldman Sachs and American Express are among those that will not need additional capital, people familiar with the situation said.
Citi and BofA emerged as the banks with the biggest capital shortfalls, with Citi’s equity needs projected to be more than $50bn and BofA requiring about $34bn in fresh equity.
However, BofA’s capital deficit is more pressing because Citi has already agreed to bolster its balance sheet by converting preferred shares owned by the government and other investors and selling non-core businesses.
People close to the situation expect Citi to have to raise no more than $6bn through the expansion of its planned conversion of preferred shares – less than the $10bn-plus the market had feared. The move could decrease the government’s stake in Citi, which was expected to be 36 per cent to about 33 per cent.
New equity ratio rule
US banks will be required to hold enough equity to ensure that they would still have a common equity ratio of at least 4% of risk-weighted assets at the end of 2010 even if the adverse scenario set out in bank stress tests were to materialise, the authorities said on Wednesday 6th May. I suggest that they should consier applying an equivalent of the Dutch National Bank’s Liquidity directive.
Banks are required to report on a consolidated level on their liquidity position to the DNB monthly, on the basis of the liquidity supervision directive. The liquidity directive seeks to ensure that banks are in a position to cope with an acute short term liquidity shortage under the assumption that banks would remain solvent. In principle, the DNB liquidity directive covers all direct domestic and foreign establishments (subsidiaries/branches), including majority participations. The regulatory report also takes into consideration the liquidity effects of derivatives and the potential drawings under committed facilities.
The directive places emphasis on the short term in testing the liquidity position over a period of up to one month with a separate test of the liquidity position in the first week. For observation purposes, several additional maturity bands are included in the liquidity report (one to three months, three to six months, six months to one year and beyond one year).
Available liquidity must always exceed required liquidity. Available liquidity and required liquidity are calculated by applying weighting factors to the relevant on- and off-balance sheet items, i.e. irrevocable commitments. The liquidity test includes all currencies. Compliance reports concerning liquidity requirements of foreign subsidiaries are submitted to the appropriate foreign regulatory authorities as required. At a consolidated level, and in every country in which a bank operates, the banking group must adhere to the liquidity standards imposed by the applicable regulatory authorities.
The use of a common equity ratio – even if as a benchmark rather than a formal future standard – is a departure from normal bank regulation. It is intended to ensure that banks have good quality capital, providing permanent capacity to absorb losses and flexibility over cash distributions.
The US authorities also said that the 19 biggest US banks will also be required to hold enough overall tier one capital to ensure that they would still have tier one capital equal to at least 6% ratio to RWA. This allows their reserve capital to operate as a cushion that can depress by half.
Banks will have 30 days to present a plan to meet the demands identified by regulators. They will also be required to outline steps they will take to “address weakness, where appropriate” in their own processes for capital planning. They are tasked to outline how they will, over time, repay existing government capital injections (e.g. in payment or in preferred shares) and reduce reliance on debt issued under a government-guaranteed programme. Up to 10 of the 19 banks are likely to need fresh equity, according to various unnamed sources. Morgan Stanley is said to need $1.5bn in new equity, as a result of its buying a majority stake in Citi’s Smith Barney brokerage.
Tim Geithner, the US Treasury Secretary, said last night on PBS: “I think the results will be, on balance, reassuring.” Investors concur, with shares in BofA, Citi and Wells Fargo – expected to need $10bn-plus in new equity – rising by over 15%.
The tests aim to ensure that even in an adverse economic scenarios, such as obviously the current crisis, banks can retain tier one capital of at least 6% of risk-weighted assets RWA – loans and other exposures less collateral, with both the assets and liabilities risk-weighted and risk-graded) and tangible common equity of at least 4% at the end of 2010 (when economic recovery should be 1 year old). Each bank told to raise additional equity has until June 8 to present a plan to regulators explaining how it intends to do so. The concern here is to have clarity in time for planning the administration’s budget for budget year starting 1 October. This is required even though further government financing will be off-budget via Federal Reserve balance sheet of T-bills, and only on-budget if requiring longer term Treasury Bond issues.
These banks will also be required to remedy any “weaknesses” (governance, systems, data quality, reporting process, risk management controls, and risk mitigation measures) in their internal capital planning (liquidity risk management) and to outline how they eventually intend to buyt hemselves out of government-sponsored aid.
The revelation that BofA needs about $34bn in extra capital will increase pressure on Ken Lewis, its embattled chief executive. The banks and the regulators declined to comment to news sources such as FT or Reuters or were unavailable.
The stress tests overseen by the FDIC involved more than 150 senior bank supervisors, analysts and economists being interrogated (subject to Geneva Convention or Basel Accord Rules) in the top 19 US banks about their likely losses in the event of a deeper-than-expected recession. This is somewhat complicated and relieved by FASB relaxaion of fair value mark-to-market valuations that takes the illiquid temporary turbulence effects out of market pricing. It is also helped that 3 month LIBOR has fallen to its lowest level since the ‘80s even if longer term funding from private sources remains a desert.
Following the policy (announced February 10) these banks were asked to estimate their short term future losses against capital to meet those losses, under adverse conditions that reflect a view of current conditions shaded on the relatively more benign side of the possible range of outcomes, as defined by the FDIC.
The teams of bank supervisors – specialising in specific types of assets, bank earnings capacity and reserves – then evaluated the banks’ submissions and asked for further information. They tested banks’ projections against independent benchmarks of their own tailored to the portfolio mixes of each bank. The problem here is that the authorities do not have complete macoeconomic models with sufficient financial sector detail to produce and adequatelyrobust and complete benchmark. It is easier to benchmark the banking sector to the economy than to directly correlate any one bank to the economy. The latter is almost impossible. The problem therefore is that whatever macro-prudential and macro-economic modelling the supervisors have to check with is not availabl to the banks themselves. There is, of course, considerable scope for judgement in these matters, but the all tolled the liklihood of the banks assessments agreeing directly with that pre-calculated by the supervisor team is zero! Hence, there will be considerable interative toing and froing between supervisor team and the bank. It may take until end of June to reach consensus agreement.
Taking into account likely losses, operating earnings (repeatable and one-offs) and own-capital reserves, the supervisors make a judgment about on whether each bank requires additional capital to guard against the risks represented by the stress test, with particular concern for whether that capital may be obtained from private sources or must be sought from the Federal Reserve, US Treasury, FDIC, and/or Congress and the White House.
There was both an overall tier-one capital test (which virtually every bank met easily) and a common equity test (which identified the need for many banks to hold economic-capital cushions against wider market and economy risks).
Supervisors did at least tell the banks about their assessment headline terms shortly in advance of visits, i.e. only last week – giving them a few days to crunch through their spreadsheets and challenge the findings. One immense difficulty of all this is that spreadsheets are not powerful enough to turn the handle on all of banks books and do not facilitate audit-trail drill-downs. We are dealing with macro- views top-down applying credit risk, market risk and liquidity risk assessments of large portfolios, large asset classes, where the magins for error greatly exceed the margins that the supervisors ant to have precision on i.e. increments of 0.25% of ratio to RWA or 0.125% of assets. Liquidity funding covers typically 30% of assets (the funding gap) and this is a larger ‘call’ on authorities financial resource than incremental top-up to Tier capital.
With assets of say $30tn of which $20tn are less than AAA, the funding gap is say $6-9tn that will require most of it rolling over perhaps within 6 months. Federal Reserve, US Treasury and FDIC balance sheets probably already have secured half of the requirement. The government is anxious not to let the banks deleverage to satisfy the remainder, and yet reluctant to be seen delivering yet more support in the $1+ trillion region, which would severely damage confidence just when the recession is hopefully in its last 2 quarters. The FDIC had also said in advance that relaining TARP and other sources of $150bn should be more than enough to see out this year. Hence, there is concern to keep the outcome of new funding requirement to below this, hence too Geithner’s plan to leverage the hedge funds into this role by offering them cheap loans to buy toxic assets. The hedge funds know they have political leverage here despite their general unpopularity (only a few notches adrift of the mistrust of the banks, except that at least bank shares are currently rising). This leverage resulted in their generous ‘exit’ clauses should they sometime down the track doubt their ability to make double-digit returns from buying up to $500bn of the banks ‘impaired’ assets.
Bankers say the authorities were willing to update their assessments in the light of changes to asset portfolios from the fourth quarter to the first quarter (reflecting FASB dispensation), but refused to put much weight on very strong first-quarter operating earnings when reaching their judgment on future revenues (which neatly agrees with maket sentiment that at first welcomed the record profits before recognising that these were mainly accounting changes and one-off gains).
Today’s announcement will in effect put banks into one of four categories: those (if any) that need extra tier-one capital; those that need to increase their equity buffer; those that have an adequate capital buffer under the stress test standard; and those that have surplus capital and could be eligible to repay bail-out funds subject to further conditions.
Nouriel Roubini and others, who with the credit ratings agencies, share one outlook in common, which is that there are no penalties just now for being excessively gloomy, advocates in good populist manner the dstruction of some banks to allows others to flourish in their place, a kind of fast-forward Darwinianism. Roubini complains that the tests have no precise insolvency threshold. In my view this is only sensible. Insolvency for banks is not a fixed moment in time event and there are at least six different ways of assessing insolvency. And, in any case, when government stands behind the banks, more so when it owns them, the normal regulatory and insolvency critieria no longer apply as before! Quoting the IMF estimates of losses, which actually added nothing we did not know already, Roubini reiterates that since losses have doubled in six months, the stress test results cannot “be credibly interpreted as a sign of bank health”. My response is, no of course not; these are not yet healthy patients. That is not the issue. The question is have they died or are the vital signs good enough, with evidence of at least near-normal brain-function not to turn off the life support?
Roubini is like a camp-doctor. These banks are cripples, let’s top them if they need “extra capital have, in fact, failed. As a result, these institutions will not be able to raise outside capital and will immediately require government help. Once again, the question will be how the near-insolvent banks can be kept afloat, to avoid systemic risk. But the question we really should be asking is: why keep insolvent banks afloat? We believe there is no convincing answer; we should instead find ways to manage the systemic risk of bank failures.” Good luck to that as a policy prescription: the complexity is mind-boggling.
Like a Eugenicist, Roubini says simply, “Trillions of dollars have been thrown at the system, just so that we can avoid the natural process of creative destruction that would take down these institutions’ creditors. Why shouldn’t the creditors bear the losses?”
He cites as counter-arguments, the “Lehman factor” and counterparty risk, the fear of being on the other side of a transaction with a failed bank”. But this includes the fact that Government is now a major counterparty and cannot risk the banks going under and all those T-bills being presented suddenly for redemption payments. Perhaps mindful of that, he suggests “a new insolvency regime for systemically important financial institutions is passed on a fast-track basis by Congress. Problem nearly solved.” Fast-tracking anything through Congress is an operational risk. I see the problem also that instead of allowing the vacuum of major failed banks to be filled by those with unreconstructed ethics, the government and regulators should continue with supporting the troubled banks in order to clean them up and ensure the country has better, ethically sounder banking. This is economically as important as anything else for the long term. Roubini has a fond belief that there is sufficient spring in the rest of the financial markets for them to rebound even if those big banks fall over. This I very much doubt. I judge that the interconnectedness of financial institutions is far far more complex a network than Roubini realises. Finance is not a competitive market mainly. The banks chased alpha unrealistically, fooling themselves into believing they are their on performance drivers. The difference in performance among banks is minor. The major factors are the economy, nationally and globally. I think Roubini should abandon a micro-theory view and get back to macro-economics.
The stress-tests, from which bankers have to learn this is how they must manage in the future, concern managing through the vicious circle between economic and financial weakness plaguing the economy, paving the way for a reliable recovery. Once that is achieved then other tinkering, Shumpeterian perhaps, is open to debate, not before.
Just now the focus is on narrowing the information gap between what bankers think banks are worth and what investors think banks are worth, they hope to enable many banks to raise the equity they need from the private market. Banks must clean up their balance sheets to attract more equity but not at the expense of the underlying economy.
Officials privately agree that the stress test is not a worst-case assessment but they argue that by intervening relatively early by the standards of past crises they can help ensure such an outcome does not materialise. The assessments are, however, based on a banker’s rather than an economist’s analysis of losses and that is their gross realism failing. They should though avoid the accountant’s snapshot view of solvency by allowing banks to value assets held to maturity at higher than current market prices, and gives them credit for their ability to earn their way back to health over time, taking account of time to generate debt recoveries.
The Federal Reserve tries to narrow the gap between the banker’s view and the economist’s view (two disttinctly different cultures) by taking a broad view of risks and a more forward-looking assessment of loan losses and recoveries. If the strategy succeeds in restoring confidence and drawing in additional equity, it should result in a decline in risk spreads on bank debt, reducing their funding costs and encouraging them to be more aggressive in lending to households and businesses. This correlates well with UK policy that has exceeded even the total support for banks of the rest of the EU. The other OECD countries will be under pressure to follow suit with publishing stress tests of their own. The EU is seeking stress tests on 47 banks, now reduced to the top 25. But these are late. This is because everyone under-estimated the difficulties of assessing scenarios and building models across so many national economies, and the lack of models appropriate to doing this work at a pan-EU level as well as individual country levels.

Friday, 1 May 2009

Banks, Bonds, and Bond Traders

It is fair comment that a feature of investment banks and governments has long been one of incestuous mutuality or let's call it conspiratorial cooperation, from the very earliest times of loan-financing the King's Treasury as an alternative to tax-hike shocks to pay for wars or any other large investments. There is too a long history of the dangers of being a government creditor before governments became more mindful of parliaments, of laws and social responsibilities to manage better the economic impacts of government finance especially when leveraged by political democracy and economic theories that inculcated those responsibilities.
We are going through a special period when governments have been digging deep into the artistry of off-balance sheet financing via central banks treasury bills to bail out the technical insolvencies of banks. Despite this massive lender of last resort help, today there is a plethora of investment analysts notes circulating with undisguised sarcasm and cynicism about government finances. Even I am amazed at how shamelessly the financial markets can turn to savage governments that are doing so much to buy them survival time through the credit crunch and recession!
Some of this is knee-jerk mindless politicking. How easy to blame governments for the so-called 'mess in which public finances are in', on the one hand decrying historically high government deficit spending while on the other complaining about the threat of higher taxation such as the UK's new 50% higher tax rate for those earning above a quarter of a million and similar higher taxation in the US. What would it be costing those who complain if the governments stuck to balanced budget targets regardless of the underlying recession? There is a cry on many sides for government spending to be cut and tax rates to be lower. We entered the crisis with historically low direct taxes (income and corporation taxes).
Some others decry the 'crowding out' effect of governments mopping up savings by issuing a few trillion of government bonds on top of the trillions of bills issued as swaps for impaired and semi-illiquid assets held by banks to reduce their writedowns and nominal losses, to protect their capital and ensure they can retain basic solvency. Given the highest credit rating of government bonds, however, crowding out is offset by the boost to economic growth compared to what it would otherwise have been (i.e. the money is not lost to the economy, but generates multiplier effects by how it is redistributed) and the Treasury bonds help leverage bank lending and have a very high collateral value to support further investment credit. Productive investment is made more by those who borrow than by those with surplus savings. Hence, the 'crowding out' view should be replaced by a 'crowding in' theory of government borrowing. There is not a simple correlation between money supply statistics and government borrowing, certainly not one that can persuade me of the simple axioms of classic monetarist precepts. But, the reality for clear-thinking economists is that lower government spending would not help the economy anyway, not the 'real economy' so-called; it would today just make the whole of the 'economic cake' smaller and postpone recovery, possibly propelling the world's leading economies into Depression (up to a decade possibly of zero, negative or low growth as Japan in the '90s, or longer, as applied economists know, The Great Depression of 1873-1896).
I can only characterise fiscal consrvatives and 'small government is better government' pundits as blinkered, unable or unwilling to see and take responsibility for the big picture! Adam Smith's 'invisible hand' hypothetical and subjective proposition was not that everyone's selfishness should be as narrowly and individually focused as possible to produce the maximum inadvertent public economic and charitable benefits. That would be patently absurdist, since it can only be obviously true that extreme selfishness would undermine national economic integrity, and similarly at the global level; income and wealth is ultimately a social product, dependent on the quality and integrity of the total system, not of each part acting independently.
The famous national debt clock in New York shows the gross debt figure, but over a third of this is are obligations between arms of government, not tradable Treasury bonds, much of which in my view should be made tradable and sold into the secondary bond market and the proceeds used to finance social programs and a large part of the budget deficit without thereby increasing the gross national debt. The internal government part of the national debt is shown by the gap between red and blue lines. In other OECD countries this debt that is internal to government is typically about 20-25% of gross national debts.
Except for the USA in recent years unless we look only at its publicly held debt which has remained fairly constant, many governments held the line in maintaining a fairly constant gross debt ratio over the last decade, the private sectors, banks, businesses and households more than doubled their debt ratios to GDP in credit-boom high trade deficit countries. But, without that the trade-surplus countries could not have maintained their growth. Indeed, it was a boon to many emerging markets. But now we see export-led economies recessing faster than deficit-led economies. An exception to prove the rule is the Bush strategy from 2001 onwards when government tax cuts and cuts in social programs, with Adam Smith's 'invisible hand' in mind as prescribed by monetary conservatists, helped secure recovery but in a severely unbalanced way that proved to be relatively 'jobless' compared to more conventional fiscal recoveries.
The private sector should not complain now when the public sector has to do substantial borrowing now. And it is very likely, anyhow, that government deficits and debt ratios may fall as ratios to GDP sooner and faster over the medium term (3-5 years) than private sector balances, especially as it turns out that much of the financing bail-out of banks proves to be profitable for taxpayers - even if taxpayer money is scarcely involved in the bail-outs. I know it is hard for taxpayers to understand that their money is not what the government is playing with in its liquidity windows and treasury bills for bank asset swaps. They readily confuse government budget deficits with bank bailouts. The two things are not the same. Government budget deficits are almost entirely fiscal responses merely to recover economic growth, not to recapitalise or restructure the banks directly.
Had governments been less prudential over the past 20 years and done more to rein in asset bubbles, property, credit markets, including most importantly the banking bubble where banks stocks grew to dominate a quarter of stock markets and nearly half of quoted compnaies' profits, then the crisis today would be less severe.
Many commentators are now talking of the Treasury Bubble as the next bubble after
the dot-com, housing, mortgages, commercial real estate, private equity, and hedge fund bubbles. This is nonsense. We can see clearly that when government takes on the liabilities of the banking sector that there is a massive net reduction in credit insurance; the government credit risk spread goes up a few tens of basis points, but private sector and banks credit risk spreads fall by hundreds of basis points.
Commentators are happily getting on their high horses about investors chasing long-term Treasury prices to loftier and loftier levels only now to find this bubble too is leaking air fast like previously emerging markets, commodity prices and oil last year, and so on. This is not the same. The demand for government paper has utility and necessity; it is not just a speculative bubble.
Long bond futures fluctuate. They may have fallen 20bp — from 143 mid-December to 123 yesterday and yield on the benchmark 10-year Treasury Note from 2.06% to 3.11% — up 51% with technical levels all over the place, but this is just to be expected camera-shake.
There is also some staking out the market in advance of the large government auctions expected monthly this year. It is not a case of too much supply and not enough demand driving prices lower, at least not anywhere except at the long end simply because at first sight very long term paper seems unnatractive at current historically low coupon rates. This does not mean that the current volumes of government borrowing are more than the markets can willingly even hungrily absorb. All that is happening is that government is testing the outer limits before settling on the optimumally cheapest maturities they can get away with.
UK and US Treasuries are also buying in their own bonds, so-called Quantitative Easing, which just looks to me like restructuring their cost of money and reducing the availability of older higher coupon paper by a significant amount to focus buyers who need government paper on new issues. The Fed said at a policy meeting weeks ago that it would buy back up to $300bn, and it didn't alter that target at last Wednesday's gathering.
Critics lambast UK and US treasuries for buying or swapping illiquid and impaired RMBS and CMBS, toxic CDOs, credit card bonds, student loans — to loan money against anything and everything! This is much exaggerated. The Treasuries are charging substantial fees and exerting 25-30% haircuts, leaving themselves with more than adequate headroom to generate substantial medium term profit that I calculate will both finance recapitalisations of banks and pay off half of medium term government budget deficits thus relieving taxpayers of the risk of sharply higher future tax rates. Personally I'd like to see these haircuts translated into lower mortgage debt for sub-prime and other troubled mortgagees.
Some analysts fear all this is dragging down the US dollar, but that correction is welcome and to be expected anyway. However, there is the usual panic reaction too that the U.S. Treasury is borrowing and spending the country into oblivion! That is just absurd doom-mongering when this accusation had been better aimed at the private sector. Last week US Treasury sold a record $26bn in 7-year notes (reasonable), $35bn 5-year notes, $40bn 2-year notes, to be followed this next week by $71bn in longer-term debt. This all seems very sensible to me. Total net borrowing needs for the second quarter are now $361bn. But, given this is for the current budget year ending September 30 the timing is quite responsible, even if massively up from the only $13bn this time last year and double the previous estimate of $165bn.
The rumours are that the US Treasury will sell 30-year bonds every month, and start auctioning 50-year bonds! In the UK long term government bond yields always fall because there is sizeable Life and Pension fund demand. This may now be the case too in the US? The issuance is needed to fund the fiscal-deficit projected to hit at least $1.75tn in 2009 and $1.2tn in fiscal 2010. The importance can be seen in the composition of foreign holders of US government paper. The high issuance is good news for the economy as the only leverage getting the economy out of the hole it is in, but there is scarcely a news source or market commentary that says so. Negative sensationalism to rattle the cages of investors and persuade them into panic buying of gold or CFDs or Treasury bills and avoid long term bonds. But no investors except those with decades long term liabilities should be buying 30-50 year bonds anyway!
For more on this see my Obamanomics blogspot. (click to via profile)