Friday, November 17, 2006

Giving credit where credit is easy

Central banks have it in their power to influence inflation by regulating interest rates or money supply. Like any other ordinary magician, they like to show you one hand, usually empty, whilst the other hand is playing some kind of trick on your expectations. The world's central bankers have been showing us the hand with interest rates in it and we have been transfixed by the power and glory of quarter point movements or non-movements.

But in the other hand, they have been madly grabbing for pulling at all kinds of ropes and levers in an amateurish attempt to keep money supply from upsetting the interest rate picture. The futility of getting the right hand on the right rope was exemplified by the recent exchange between Bernanke and Triche as critiqued here and elsewhere.

It appears that the real problem with trying to use money supply as a monitorist tool is that it is "too hard". That is, the metrics are just not reliable. This has led to such silliness as dropping the publication of M3 money supply by the US Federal Reserve.

You would think, if Bernanke was prepared to stop publishing M3 data because it was unreliable, that they would also stop publishing much of the other stuff that comes out of the BLS, too.

But it is one thing to simply drop the hand with the money supply in it whilst hypnotising the crowd with the interest rate hand, and another thing to cut that hand off altogether. And there is a risk, not insubstantial, that giving up on money supply because it is too difficult to measure, will lead to everything "getting out of hand" as it were. See Drowning in the stuff and no way to control the tap.

So, here, dear reader, you should don your scuba gear because Guambat is about to get deeply in over his head: Guambat reckons the Fed should make some heavy and very public use of its regulatory powers and begin to put the easy credit genie back in the bottle.

As long as credit is as easy as it obviously is, and as long as new "instruments" and "structures" can be concocted to further increase the "leverage" in the system, money will have no real store of value and inflation is bound to pop out of the hat instead of the rabbit and dove.

Guambat does not come by any of this opinion by way of independent research and analysis. Guambat only knows what he reads in what passes for the paper theses days, the web of online news and blogviews. And this is the sort of stuff that has led to Guambat's befuddled conclusions:

Worst to First: Refco, Delphi, Bonds Beat Market
Hedge funds, fortified by $110 billion of new money from institutional investors, are snapping up the highest-yielding, highest-risk junk bonds.... [Would this be at all related to the surging interest in CDSs and CPDOs?.]

"I'm as surprised as anyone that we're having a rally in dreck," said Marilyn Cohen, who manages $225 million of bonds as president of Envision Capital Management in Los Angeles.

"The leveraged debt market has seen explosive growth." (Tom Connolly, co-head of leveraged finance and one of two Goldman Sachs Group executives overseeing origination and distribution of high-yield, high-risk bonds and loans.)

The surge in prices of distressed-debt bonds may be a sign that the market has reached a peak, said Envision Capital's Cohen. ``For anyone to say this isn't overdone, I think is insane,'' she said.

Why new hedge rules? By STEVEN PEARLSTEIN
[T]he Securities and Exchange Commission and the Commodity Futures Trading Commission are about to adopt new rules that would in effect lower the amount of their own money that hedge funds or any large investor must put up to buy and hold stocks, options, swaps, futures and other derivative products.

As it happens, this reduction in margin requirements is being pushed not so much by the hedge funds themselves as by the brokerage firms that handle their transactions and lend them the money, along with the New York Stock Exchange and the Chicago Board Options Exchange.

The initiative is known as portfolio margining, and the theory behind it is certainly sound.

Under current rules, which date to the 1930s, an investor has put up at least 25 percent of the cost of buying a stock. That way, the broker still has enough collateral to cover the loan as long as the share price doesn’t fall by more than 25 percent.

But these days, sophisticated investors don’t trade just in stocks. So why not allow the broker to use sophisticated computer programs to look at an investor’s entire portfolio, determine the real risk to the lender once all the bets and hedges are netted out, and adjust margin requirements accordingly?

Actually, there are two reasons.

One is that these risk-management systems aren’t as infallible and impervious to manipulation as the industry would have us believe. Under the proposed new rule, all brokerage houses would be required to use the same, relatively simple modeling system designed by the leading options clearinghouse that considers a limited number of trading instruments.

The other reason for skepticism is that margin requirements serve a broader purpose than simply making sure brokers have enough collateral to get their loans repaid. These rules were put in during the 1930s because of a widely held belief that highly leveraged trading had contributed to the stock-market bubble and crash that preceded the Great Depression. And what was true then is still true today.

Hedge funds should not be leveraged by Steve Waldman
My inner Roubini has been kicking the shit out of my inner Cramer for more than a year now. So it was with some surprise that I found myself nodding along and murmuring "Amen" to Cramer's New York magazine piece on hedge funds, After Amaranth.

Cramer makes some pretty obvious, good points. Like, since hedge funds are supposed to be for highly risk-tolerant investors, pension funds oughtn't be in the game.

This got me thinking. Why should hedge fund be leveraged at all?

"What?!? Hedge funds are all about leveraged investment strategies!" I know, I know. But hear me out.

Hedge funds are for rich people, with lots of capital and risk tolerance, right? So why shouldn't hedge fund investors — people with sophisticated access to capital and credit markets — lever themselves, investing in unlevered funds with their own borrowed money? Theoretically, unless hedge fund investors are trying to take advantage of their creditors by forcing them to bear much of the risk, the return characteristics of a leveraged fund and those of an unleveraged fund purchased with borrowed money are exactly the same.

And while investors may enjoy letting their bankers share much of the downside of their investments, there's little reason to think this is good for the rest of us. It hardly seems fair for the public to bear systemic risk in order to enhance the private returns of the wealthy.

If hedge funds were themselves unlevered, bank exposures to hedge fund risks would be much less (as investors would have to go bankrupt before banks could get stiffed), and better diversified (as the cost of a big fund meltdown would be spread among the many banks who lent to various investors, rather than concentrated in the one bank that lent to the fund). Also, investors could better tailor their hedge-fund investments to their own level of risk tolerance.

Finally, without leverage, hedge funds would have to compete based on the intelligence of their investments, rather than their ability cajole bankers into lending them too much money, too cheaply. In such a world, it might actually be true that these funds would fuction to squeeze inefficiencies out of markets, rather than highlight and take advantage of conflicts of interest between bank managers, depositors, and governments..

I'm not suggesting that hedge funds shouldn't be able to borrow at all, as many hedge-fund strategies, like going short, require borrowing. And the implicit leverage inherent in many derivatives positions would represent a challenge to any regime that purported to regulate hedge fund leverage without otherwise limiting investment cleverness. Nevertheless, at least in theory, is there any good reason why limited liability investment funds for the rich and creditworthy should be permitted to take on high degree of leverage?

Endless Credit Creation by Puru Saxena
Although I concede that the rate of inflation (money-supply growth) in the United States has been in decline since 2002; bank credit continues to grow at a record-pace - $4.4 trillion annualized in 2006 compared to $3.3 trillion last year. So, there is no scarcity of money and credit today.

In the past, whenever the central banks were serious about monetary tightening, credit contracted in a meaningful way compared to the previous year. After all, monetary tightening has one prime objective: to curtail the excesses in the economy and capital markets. On this account, the central banks have done a poor job of tightening as credit growth (not captured in the money-supply figures) is still in the stratosphere.

In summary, money-supply growth has contracted somewhat due to rising short-term interest-rates, but this has been largely offset by a surge in bank credit, thereby making the monetary tightening ineffective.

And having the bloody Bank of Japan loaning money they just know is being "carried" around the world basically interest-free doesn't help one little bit.

And then there's "Private Equity". Just as booming era companies created their own money supply from highly inflated corporate script to buy out other companies, today's financial swash-bucklers create their own money by highly leveraged snatch-and-run buy-outs. See the Hertz deal, for instance. The thing that makes that bit of pretty larceny work is easy credit that the Carlyle Group, KKR and others can tap into. Those deals put billions of newly "released" (created) money into the system without increasing the economic value of the company one iota. "So far this year, a total of 1,081 private-equity deals in Europe have been arranged valued at $206.99 billion, according to data supplied by Thomson Financial. [That] compares to 1,205 deals worth $169.4 billion completed in all of 2005." And that's just Europe!

As Bernanke said, “The rapid pace of financial innovation in the US has been an important reason for the instability of the relationships between monetary aggregates and other macroeconomic variables.”

The Fed would go a long way to containing nascent inflation without having to raise interest rates if it took a stronger banker's hand to the credit creation tools at its disposal.

But that's just the view from this Guambat's burrow. Guambats don't soar with the eagles and lack their keen eyesight, too.


Anonymous Anonymous said...

I've come across an intriguing article explaining how to define inflation in relation to the Federal Reserve and large banking interests. Interesting indeed.

7 December 2006 at 7:55:00 am GMT+10  

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