New Economist

IMF: "Risks to financial stability have intensified"

For those hoping that credit conditions might gradually be returning to normal, today's IMF Global Financial Stability Report market update contained a stark warning:

Risks to financial stability have intensified since October 2008. Macroeconomic risks have risen as global growth has fallen precipitously alongside a sharp slowdown of global trade. Credit risks have also risen as a deterioration of economic and financial conditions have resulted in rising loan losses. At the same time, the flight from risky assets and illiquid market conditions has increased funding costs, even as risk-free rates have declined with monetary easing.

That is despite the massive bailouts, spending plans and other government interventions we have seen since the last report:

...With the help of extensive government support, market functioning toward the end of 2008 improved in a number of asset classes. However, the negative interaction between the economy and the financial sector has intensified as the credit crunch bites harder and extends globally, with confidence among financial counterparties remaining strained. Indeed, the recent shock to bank earnings and other bad economic news has put further downward pressure on bank equity prices, and the width of credit default swap spreads points to still-elevated systemic risks.

And if you think that prognosis was depressing, the sentence that follows is even worse:

Notwithstanding public injections of capital, many banks around the world may have an insufficient capital cushion to weather a deep global economic downturn.

Translation: many banks are insolvent and probably won't survive the global recession.

The credit crunch ain't over; not by a long shot.

The credit crunch: what happened?

While Ken 'worst is yet to come' Rogoff is trying his level best to scare global financial markets about the credit crunch, research is now starting to filter through about just what happened last year. A new IMF working paper by Nathaniel Frank, Brenda González-Hermosillo and Heiko Hesse, Transmission of Liquidity Shocks: Evidence from the 2007 Subprime Crisis, does some of the spadework. As they explain, liquidity crisis soon segued into a solvency crisis (think Northern Rock, Bear Sterns):

It is found that the interaction between market and funding illiquidity increased sharply during the recent period of financial turbulence, and that bank solvency became important. ...What started out as a liquidity crisis, turned into a solvency issue.

It wasn't simply credit that dried up, it was trust - the whole basis of interbank money markets. Banks were unwilling to trust the disclosures or assurances of their counterparties. As a result central banks had to pump hundreds of billions into financial markets to address the liquidity spiral and to ensure the solvency of key financial institutions.

So why did these interactions and correlations spike when the sub-prime crisis hit?

The analysis presented here suggests that increasing financial integration and innovation can make market and funding liquidity pressures readily turn into issues of insolvency.

The easy answer would be to blame the quants and financial engineers. But the real culprit was greed, reinforced by the lousy risk management and lax prudential standards of most major banks (and their clients, many of whom bought products they did not understand). While the money kept rolling in the door, senior managers were quite happy to avert their eyes to the ever-mounting risks.

I was not surprised by the sub-prime crisis; it was an accident waiting to happen. But I didn't expect the credit crunch to have been protracted, particularly once central banks interviened with such gusto.

Rogoff is probably right to say that we are only about half-way through the crisis. But the key issue for me is not whether another major bank goes bust (some of them clearly deserve to). It is whether the risk of US recession is now receding (a U-shaped downturn), or whether we are instead facing a 'W'-shaped downturn, with another growth dip looming. So far my controversial call of no US recession this year has held up, and I still think I am odds on to be proved correct. But the outlook for 2009 has becoming bleaker; there are now too many uncertainties to rule out an eventual recession.

Cityphilia

Like most of us I have been reading a lot of commentary about the credit crunch lately. A more personal perspective about the City and the recent crisis is presented by John Lanchester in the latest London Review of Books. Here is a short extract from his piece, Cityphilia:

This uncritical and uninformed governmental Cityphilia received its biggest shock in decades this autumn, with the near collapse of Britain’s fifth largest mortgage lender, Northern Rock. Britain’s first genuine bank run in more than a hundred years shone a light in many places where the sun doesn’t routinely shine, and one of the first things to be brought into question was the ways banks work.

As I’ve already said, my father was a banker, and I grew up hearing about that mythical beast, the bank run. It was often spoken of but rarely seen in the wild. Bankers are said to dread a bank run, but my dad talked about them with a certain black humour. They were always a sign that somebody had fucked up, big-time. They can also be a sign that something in the financial system is fundamentally wrong.

The question hanging around in the residue of the Rock’s near implosion is which type of bank run this was – a fuck-up, or a harbinger of meltdown?

What drives the growth in FX activity?

Earlier this year the Bank for International Settlements published their Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity. The survey reported a massive jump in daily turnover:

Turnover in traditional foreign exchange instruments increased by an unprecedented 71% to $3.2 trillion.

What has been driving this upsurge? The latest BIS Quarterly Review includes a 10 page article which offers an explanation: What drives the growth in FX activity? Interpreting the 2007 triennial survey The three main factors identified by BIS authors Gabriele Galati and Alexandra Heath appear to be hedge funds, portfolio diversification of pension funds, and higher turnover of emerging market currencies:

Two specific findings stand out. First, the growth in transactions between banks and other financial institutions was particularly strong, consistent with the increasing importance of hedge funds, as well as portfolio diversification by institutional investors with a longer-term horizon, such as pension funds. Second, there has been a marked increase in turnover involving emerging market currencies.

The first two are not much of a surprise. The third can be seen as a by-product of the very healthy economic and trade performance of many emerging economies in recent years. In the past many emerging currencies had remarkably low fx turnover for the size of their economies; less so now.

Has the City lost its cool?

It's not quite The Beano Annual, but you know that Xmas is approaching when the Economist's annual glossy hits the newstands. In a pleasant change, most of the content of The World in 2008 is available free online. Another (new?) development is that author's names are now included - still famously not the case in the weekly.

One piece that caught my eye was a short piece by Lionel Barber, editor-in-chief at the Financial Times, warning of "tougher times ahead" for the City in 2008: London loses its cool

Host of the 2012 Olympic games, financial rival to New York, magnet for football-mad billionaires: London’s reputation as cool, classy and cosmopolitan has never been higher. The capital’s dynamic growth has been driven by the City of London, the location of choice for hedge funds, private-equity firms and Wall Street exiles. Thanks to a favourable tax regime, light regulation and an open-armed welcome to foreigners, the City is the bejewelled crown of Britain’s economy.

But that crown is in danger of slipping in 2008. Even before the great credit squeeze of 2007, there were clear signs that mergers and acquisitions as well as private-equity buy-outs had peaked. The return of conservative risk management in the banks and hedge funds will be a prominent theme in the coming year. Inevitably, this will lead to staff culls, lower Christmas bonuses and the disappearance of the more exotic off-balance-sheet financing which proliferated in the era of cheap money.

In 2008 investment banks will still be digesting the more leveraged deals struck at the height of the debt-driven boom. Some of these deals may fall by the wayside; others will have to be renegotiated. As one prominent banker says: “We will still see M&A activity in London, but it will be more of the mid-size and small-cap end rather than the really big deals.”

Private equity, which has enjoyed mouth-watering returns, will have a far tougher time in 2008. Not only has competition increased; the industry’s image has taken a beating amid accusations of asset-stripping and unduly favourable tax treatment. Gordon Brown’s government may tinker further with the tax code, but not enough to drive wealthy partners and non-domiciled London residents to sunnier (or snowier) tax havens such as Monaco or Switzerland.

Private equity: who profits?

Private equity has been growing rapidly in recent years, presumably reflecting superior performance? Maybe not. A new study for the European Commission by Oliver Gottschalg from HEC business school in Paris suggests a quite limited improvement in returns, and which is scooped up in management fees. Martin Arnold reports in today's Financial Times: Doubt cast on buy-out firms' huge profits

Based on data from 6,000 private equity deals and about 1,000 buy-out funds, the survey shows that average private equity returns have underperformed the benchmark S&P 500 share index by 3 per cent, after fees charged to investors.

"This does not correspond with the stereotype of the industry making its investors extremely rich," Oliver Gottschlag, who compiled the research, told the Financial Times. "Investors have not had much fun in this asset class, even though they have all been obsessed with gaining access to the best-performing funds."

Excluding fees and carried interest (a widely-used profit sharing scheme), returns from private equity outperformed the S&P 500 by 3 per cent.

"So private equity is generating value somewhere, but its fee structure means the general partners capture double the out-performance they generate," said Mr Gottschlag, who is also head of research at Peracs, an adviser to buy-out investors.

The research was based on data collected from investors in 852 private equity funds raised before 1993, to be sure they had sold all their assets. But Mr Gottschlag said analysis of more recent funds showed their performance had been similar.

In a related piece, Another black mark, Gottschlag explains why reporting of equity returns is misleading:

He argues the internal rate of return (IRR) measure used as a benchmark by most buy-out firms is "misleading" as it exaggerates profits and disguises poor performers.

"Our research shows the way private equity fund performance is most often reported overstates the truth," Mr Gottschlag writes in next month's Harvard Business Review.

The IRR measure assumes that any cash proceeds returned early to investors is reinvested at the IRR rate over the investment period, which risks inflating performance.

Stripping out this inflationary effect - by assuming early cash to investors is invested at a 12 per cent return - Mr Gottschlag said the IRR of the top performing fund in his sample of 1,184 firms fell from 464 per cent to just 31 per cent.

I cannot find the UC paper on the web. But an earlier working paper, Performance of Private Equity Funds, is available online.

Explaining the T-bond 'conundrum'

In February 2005, then Fed Chairman Alan Greenspan referred to the decline in long-term rates in the wake of the Fed increasing the target for the federal funds rate by 150 basis points as a "conundrum" St Louis Fed's Daniel L. Thornton has investigated Greenspan's remarks and provides an answer, in a new working paper: The unusual behavior of the federal funds and 10-year Treasury rates: a conundrum or Goodhart's Law?

I show that the relationship between the 10 year Treasury yield and the federal funds rate changed dramatically in the late 1980s, well in advance of Greenspan's observation. I argue that the marked change in the relationship between the federal funds rate and long-term yields is a natural consequence of Goodhart's Law.

Here is what happened:

Once the Fed began targeting the funds rate for policy purposes and the funds rate remained close to the target, the behavior of the funds rate is necessarily different from what it would have been had it been free to respond to market fundamentals. This implies that the relationship between the funds rate and rates that are less closely linked to the funds rate would necessarily change. Since long-term yields are much less affected by the funds rate than other shorter-term rates, it is reasonable that the relationship between the funds rate and long-term rates would be most affected.

This hypothesis is supported by the fact that there was a marked change in the relationship between changes in the 10-year Treasury bond yield and changes in the federal funds rate that occurred in the late 1980s. The change in the relationship is statistically significant at monthly and quarterly frequencies. Moreover, an analysis of the levels of these rates indicates that the change persists at lower frequencies as well.

Some of you may not have heard of Goodhart's Law. It was coined by British economist Charles Goodhart in the mid-1970s, when he was was Chief Adviser to the Bank of England. The basic idea is that when a government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends. This proved prophetic when Margaret Thatcher was elected Prime Minister in 1979, and sought - disastrously - to conduct monetary policy on the broad and narrow money supply targets.

UPDATE:
Almost as soon as this post went up, another paper on the same subject appeared. Cracking the Conundrum, by the Stern School's David Backus and Federal Reserve economist Jonathan H. Wright, has just been published as Finance and Economics Discussion Series No. 2007-46. The authors hedge their best a little more than Thornton, citing several possible contributing factors:

From 2004 to 2006, the FOMC raised the target federal funds rate by 4.25 percentage points, yet long-maturity yields and forward rates fell. We consider several possible explanations for this "conundrum." The most likely, in our view, is a fall in the term premium, probably associated with some combination of diminished macroeconomic uncertainty and financial market volatility, more predictable monetary policy, and the state of the business cycle.

I accept there was a decline in the term premium (the expected return on long-term bonds). But surely this begs the obvious question: 'why?'. A post by James Hamilton of Econbrowser fame provides some discussion: The term premium and reduced volatility

Crisis? Why crisis?

It is probably a little too early yet to know exactly what went wrong and who is to blame, but in the UK at least monetary and finance economists are starting to provide some answers.

This afternoon the LSE's Financial Markets Group hosts a half-day Financial Crisis Conference. I attach the draft agenda (PDF), which includes Charles Goodhart, Willem Buiter and the FT's Gillian Tett, among others. The web page states: "This is an open event and registration is not required. Please arrive early as places are limited".

Former MPC member Buiter has posted a copy of his powerpoint presentation 'What should the authorities have done?’ online. He summarised his arguments in a long post on his new weblog, Maveronomics, which begins thus:

The mess surrounding the rescue operation for Northern Rock demonstrated that the UK’s Tripartite arrangement for handling financial crises is not working properly.

There are three distinct sets of problems. First, the UK deposit insurance scheme is both limited in the degree to which it guarantees retail deposits and too slow in paying out on any claims submitted under the scheme.

Second, the division of labour among the Treasury, the Bank of England and the Financial Services Authority, as expressed in the Memorandum of Understanding, was disfunctional, mainly because it separated the agency in possession of the relevant information from the financial resources to act effectively upon that information.

Third, the Bank of England’s liquidity-oriented open market operations through repos, and its discount window are flawed in three ways: first, the eligible collateral is too restricted; second, the maturity of the operations (loans) is too short; and, third, the list of eligible counterparties is too restricted.

Specifically, five issues can be raised about the current set of arrangements:

(1) The UK deposit insurance arrangements did not work properly.

(2) The lender of last resort (LOLR) mechanism for dealing with individual financial institutions in distress did not work properly.

(3) The Bank of England’s Standing Lending Facility (its discount window) did not work properly.

(4) The Bank of England’s liquidity-enhancing open market operations did not work properly.

(5) The financial stability mess, and the Bank’s about face as regards the collateral requirements and the maturity of its liquidity-enhancing open market operations have created confusion about exactly what it is the Monetary Policy Committee decides on when it sets the official policy rate, or Bank Rate.

Why do firms use private equity?

Speaking at a Yale finance and accounting seminar later today, Amy Dittmar from the University of Michigan asks a very pertinent question: Why do firms use private equity to opt out of public markets? (PDF).

Written with co-author Sreedhar T. Bharath, their paper employs a comprehensive sample of going private transactions from 1980-2004 in the US. Their model does a remarkably good job of predicting which public firms will go private:

Using only data at the time of the IPO, we are able to correctly predict who will go private 80.6% of the time. This result implies that it is not only the path that the firm takes but factors inherent and observable about the firm at the time of going public that determines if it eventually will go private.

And what is driving those decisions? They accord well with theory:

Our results provide strong support for the importance of information and liquidity considerations in being a public firm. Access to capital and control considerations become increasingly important over the public life of the firm. We also find that the information and liquidity factors that drive the firms to go private are evident at the initial public offering, on average thirteen years before the going private decision.

A nice piece of research.

Was it really due to easy money?

Yale's Robert J. Shiller has a forthcoming article in the Brooking Papers on Economic Activity which questions the popular interpretation that asset booms since the mid 1990s were a direct consequence of falling long-term interest rates. The paper, Low Long-Term Interest Rates and High Asset Prices (PDF), was prepared for a "Celebration of BPEA” Conference being held at the Brookings Institution last week. Here are Shiller's conclusions:

We have seen here that the big movements in stock prices and real estate prices in the last decade or so do not line up with movements in long-term interest rates over the same time period. This appears to confirm the 1988 results of Campbell and Shiller that stock prices relative to dividends or earnings are not well explainable in terms of present value models with time-varying interest rates.

Yet if we are doing very broad comparisons of the present time with another time, comparing the early 1980s when interest rates were very high with today, we might say that lower nominal interest rates are indeed a factor in the relatively higher asset prices we see today. ...Presumably, as I discussed in Irrational Exuberance, there are many factors, including speculative feedback, that have contributed to high asset prices today.

This paper began by considering a certain common belief about the way the world works which was motivation for this paper. We see that the idea that we should think of the level of long-term real interest rates as the dominant force in driving long-term asset prices up or down is not supported by the evidence.