Category Archives: Financial Markets

No, Robert E. Hall, that’s not actually the only problem

Matthew Klein has a good post taking down Robert E. Hall’s claim that reserves are lend out. It’s annoying that supposedly intelligent professors and central bank advisors don’t understand how the monetary system works.

He quotes from Hall’s Jackson Hole paper:

Paying an above-market rate on reserves changes the sign of the effect of a portfolio expansion. Under the traditional policy of paying well below market rates on reserves, banks treated excess reserves as hot potatoes. Every economic principles book describes how, when banks collectively hold excess reserves, the banks expand the economy by lending them out. The process stops only when the demand for deposits rises to the point that the excess reserves become required reserves and banks are in equilibrium. That process remains at the heart of our explanation of the primary channel of expansionary monetary policy. With an interest rate on reserves above the market rate, the process operates in the opposite direction: Banks prefer to hold reserves over other assets, risk adjusted. They protect their reserve holdings rather than trying to foist them on other banks. An expansion of reserves contracts the economy.

My emphasis. I don’t know what textbook Hall is reading, but that is so not true. A simple exercise will explain why. Say Bank X think it has too many reserves, and wants to reduce them by buying longer dated US Treasuries. Bank X finds a seller and transfers the money, receiving a bond in return. The seller of the bonds give up the bonds, but receive money in return, which will be deposited somewhere, thus leaving the total amount of reserves unchanged. The only way that the total amount of reserves change is if it is the Federal Reserve selling the bond! If only Hall had read Barnejek’s post from May, we would not have this paragraph.

This shouldn’t be hard. However, Klein is nice to Hall, because he could have kept going. Here’s the next paragraph from Hall’s paper:

The only excuse for not cutting the reserve rate is the belief that short rates would fall and money-market funds would go out of business. This amounts to an accusation that the funds are not smart enough to figure out how to charge their customers for their services. Traditionally, funds imposed charges ranging from 4 to 50 basis points, in the form of deductions from interest paid. A money-market fund using a floating net asset value can simply impose a modest fee, as do conventional stock and bond funds. The SEC may accelerate this move by requiring all money funds to use floating NAVs.

No it is not. Let me give you some reasons and a reading list:

This is just a very quick post. But, errr, tenured professors should now better.

What have we learned from Danish negative deposit rates?

I was going to do something on negative rates, but I’m busy and Nordea has written a good primer, and I still think me and Izzy’s post from July last year when they were introduced is pretty good.

Nordea: Denmark Update: Negative interest rates — the Danish experience
FT Alphaville: The ‘natural experiment’ of negative deposits rates in Denmark
St Louis Fed publication: How Low Can You Go? Negative Interest Rates and Investors’ Flight to Safety [hat tip to Toby Nangle]

I might do a little more tomorrow.

Largest arb ever based on renegotiated ISDAs?

Tracy Alloway pointed me to this cool story today, about a very large arb. It was an arb of the US Treasury vs. TIPs market. Izzy has previously written about it (#1, #2, #3, #4). The trade was rather simple; you took a position in TIPs, hedged out the inflation, and shorted UST. This was the trade:

Screen Shot 2013 05 02 at 11.35.09 PM Largest arb ever based on renegotiated ISDAs?

And the graph of the mispricing:

Screen Shot 2013 05 02 at 11.49.06 PM Largest arb ever based on renegotiated ISDAs?

Now quite a few words have been written about the trade. What I found particularly interesting about the write-up, though, was how the Barnegat Fund was able to keep the position. They did/do three things: (i) hold 50% of the fund as unencumbered collateral, (ii) returned money to investors in 2005 and 2007 when there were no opportunities, but asked for more in 2008 (and got it) when there were lots of opportunities, (iii) and then there’s this:

When you negotiate an ISDA (the governing document for derivatives) with a counterparty, they begin by sending you a proposal that says if you lose 15% in 1 month, 25% in 3 months or 35% in a year, they have the right to close you out of your position. Our documents have clauses of 20% in 1 month, 30% in 3 months or 40% in a year. That is a slight improvement, but not a huge factor. The big advantage we had over our competition was that if the counterparty wanted to terminate us, it would have to be at mid. Standard ISDAs detail how the counterparty can unwind your trades at their side of the market. This is an invitation for profit for the market maker. They can declare where the “bid” is and sell to themselves at insane levels. Most of our hedge fund competition got destroyed in this fashion in 2008. We hit the triggers, just as most others did in 2008, but no one wanted to close us out at mid. In a perfect example, a huge American bank came to us in 2008 and said that they had looked through all of their ISDAs and they had only given this clause away twice in their history. Barnegat had a huge advantage over the market in that sense.

This is really quite something. Barnegat kept their positions, because the banks couldn’t close them out at their own bids, but had to do it at the mid point. Score one for negotiation skills. This reminds me of a certain London whale, but I guess the lesson to take is that (i) there’s a rather big difference between dealer bid/offer and mid point prices, and (ii) read the contracts you sign and prospectuses for stuff you buy.

Luxembourg AAA? Really?

Pictet with the graph:

Debt to gdp and banking size Luxembourg AAA? Really?

And what’s the verdict from the rating agencies for Luxembourg?

Moody’s: Aaa
S&P: AAA
Fitch: AAA

Err, okay, then. Hat tip Barnejek.

The ECB can deal with bank funding problems

Benoît Cœuré from the ECB is usually the best when it comes to writing (and speaking) about the transmission mechanism and market operations. Since he’s responsible for Market Operations; Payments & Market Infrastructure; and Research that’s probably not too weird.

He gave a speech today in Dublin, which concludes:

In the nearer term, how can the impediments to bank funding of SMEs be addressed? In essence, these impediments are of three types: the banks’ own funding conditions, their perception of the credit risk of their clients, and lack of capital. The ECB does not have a magic wand. The central bank cannot compensate for a shortage, or a misallocation of equity. That is something that has to be addressed, in one form or the other, by other stakeholders. Neither can the central bank alter the credit risk of individual borrowers, although governments can have an impact here through reforms that improve the operating environment of those firms – labour and product market regulation for instance. Where the central bank has a direct role, within its mandate, is primarily with respect to bank funding conditions. Indeed, the ECB has taken and will continue to take appropriate measures to ensure that bank funding is not a source of financial fragmentation or an impediment to bank lending. It is reasonable to think that simultaneous action on all three counts, by the relevant stakeholders in each case, would be mutually reinforcing.

While I’m not entirely convinced that the ECB can’t do more than “continue to take appropriate measures to ensure that bank funding is not a source of financial fragmentation,” I guess he might be using ECB speak to tell us they can. Or maybe not. His slides are important, though. They show some very interesting trends (although not really breaking news): Screen Shot 2013 04 11 at 5.04.21 PM The ECB can deal with bank funding problems Screen Shot 2013 04 11 at 5.04.29 PM The ECB can deal with bank funding problems Screen Shot 2013 04 11 at 5.04.48 PM The ECB can deal with bank funding problems Screen Shot 2013 04 11 at 5.04.59 PM The ECB can deal with bank funding problems

And finally, a chart showing how SMEs fund themselves. This is interesting when thinking about QE in the eurozone as opposed to the EU. The liabilities side of the balance sheet of European corporates is very different:

Screen Shot 2013 04 11 at 5.04.55 PM The ECB can deal with bank funding problems

All slides here.

‘Love letters’

One exam done. So I was reading up on capital controls and a lot of people seem to make the Cyprus-Iceland analogy, which got me thinking about how Icelandic banks used to issue ‘love letters’ to each other. The ‘love letter’ was debt issued by the banks. Then they swapped that debt with other banks, and then used it as collateral for central bank liquidity. Here’s Anne Sibert:

Surprisingly, it was not just the Central Bank of Iceland that was willing to make loans against love letters – the Eurosystem was as well. Between the start of February and the end of April 2008, subsidiaries of the three large Icelandic banks, Kaupthing, Glitnir and Landsbanki, increased their borrowing from the Central Bank of Luxembourg by €2.5 billion. A significant amount of their collateral was in the form of love letters (Hreinsson et al. 2009, p44). It is questionable whether Icelandic bank debt should have been acceptable as collateral in the Eurosystem for any borrower. Given their inter-linkages, the Icelandic banks’ fortunes were far too highly correlated for one Icelandic bank’s debt to be satisfactory collateral against another Icelandic bank’s borrowing.

By late April 2008, the ECB had become concerned about its loans to Icelandic banks and on 25 April, the ECB President, Jean-Claude Trichet, phoned Icelandic central bank governor Davíð Oddsson and demanded a meeting with Icelandic banks and monetary and regulatory authorities (Hreinsson et al. 2009, p44). As a result, an informal agreement was made in Luxembourg on 28th and 29th April to limit the use of love letters as collateral. This proved ineffective. By the end of June, loans to the Icelandic banks had risen sharply to €4.5 billion. At the end of July, the Central Bank of Luxembourg finally prohibited the further use of love letters altogether and lending to Icelandic banks fell back to around €3.5 billion. In the autumn of 2008, five counterparties defaulted on their Eurosystem loans and three of these were subsidiaries of the large Icelandic banks (European Central Bank 2009).

From the ‘Causes of the Collapse of the Icelandic Banks‘ chapter from the Report of the Special Investigation Commission, we have the following tidbit from what happened there (p. 45):

The problem now was not only the unprotected „love letters“ being put forth as collateral for the loans at the ECB but also the currency swap agreements that were in force inside of the asset backed securities. It is clear that the Icelandic banks had angered the governors of the Central Bank of Luxembourg and the European Central Bank. At the end of July the three banks were in fact prohibited from using each others securities as collateral for loans from the European Central Bank which was effective. In general, the conduct of the Icelandic banks which has been described here, can be thought to have played a part in the fact that Iceland became eliminated from the scene of European Central Banks, but this, in return, made it more difficult for the CBI and the Icelandic government to raise liquid funds, see a more detailed discussion later in this chapter.

Also we have these graphs:

Screen Shot 2013 03 29 at 10.16.45 AM Love lettersScreen Shot 2013 03 29 at 10.11.46 AM Love lettersScreen Shot 2013 03 29 at 10.16.43 AM Love lettersScreen Shot 2013 03 29 at 10.16.27 AM Love letters

Which leads us to this announcement from the ECB:

On 20 March 2013 the Governing Council adopted Decision ECB/2013/6 on the rules concerning the use as collateral for Eurosystem monetary policy operations of own-use uncovered government-guaranteed bank bonds. Under this Decision, from 1 March 2015, the use of such bonds issued by the counterparty using them or an entity closely linked to that counterparty as collateral in Eurosystem monetary policy operations will be prevented. The Governing Council also decided to amend the rules on the use of uncovered government-guaranteed bank bonds for the period ending on 28 February 2015. To this end, the Governing Council adopted Guideline ECB/2013/4 on additional temporary measures relating to Eurosystem refinancing operations and eligibility of collateral and amending Guideline ECB/2007/9 (recast), the provisions of which encompass several existing legal acts on temporary measures. Finally, in order to clarify the overall framework, the Governing Council adopted Decision ECB/2013/5 repealing Decisions ECB/2011/4, ECB/2011/10, ECB/2012/32 and ECB/2012/34.

So everything is fine until March 1, 2015. This is — it seems to me — some housekeeping post-financial crisis. In the case of Cyprus, this bit is relevant from the original press release:

As a result, the national central banks of the Eurosystem will now only be allowed to reject eligible uncovered government-guaranteed bank bonds as collateral if they have been issued by the counterparty itself and do not comply with the Eurosystem’s minimum credit rating threshold.

Unlimited liquidity in other words, unless the ECB decide to go all nuclear again.

[And no -- this is not a perfect analogy, but it's kind of interesting since there are a few similarities. Don't over-interpret it.]

Two-tiered Europe, redux

Relatively silence from this end as of late, given other commitments (mostly exams.) I did stump upon this paper from the ECB yesterday, though, which elaborates on the discussion of the two-tiered Europe. A couple of nice graphs:

Screen Shot 2013 03 26 at 1.01.11 AM Two tiered Europe, redux

Screen Shot 2013 03 26 at 1.01.13 AM Two tiered Europe, reduxAbstract:

The Euro area economic activity and banking sector have shown substantial fragility over the last years with remarkable country heterogeneity. Using detailed data on lending conditions and standards, we analyse how financial fragility has affected the transmission mechanism of the single Euro area monetary policy during the crisis until the end of 2011. The analysis shows that the monetary transmission mechanism has been time-varying and influenced by the financial fragility of the sovereigns, banks, firms and households. The impact of monetary policy on aggregate output is stronger during the financial crisis, especially in countries facing increased sovereign financial distress. This amplification mechanism, moreover, operates mainly through the credit channel, both the bank lending and the non-financial borrower balance-sheet channel. Our results suggest that the bank-lending channel has been partly mitigated by the ECB nonstandard monetary policy interventions. At the same time, when looking at the transmission through banks of different sizes, it seems that, until the end of 2011, the impact of credit frictions of borrowers have not been significantly reduced, especially in distressed countries. Since small banks tend to lend primarily to SME, we infer that the policies adopted until the end of 2011 might have fallen short of reducing credit availability problems stemming from deteriorated firm net worth and risk conditions, especially for small firms in countries under stress.

Banks’ CA holdings, excess reserves, and recourse at the deposit facility

From the ECB’s monthly bulletin, out yesterday.

Screen Shot 2013 03 15 at 2.19.06 AM Banks CA holdings, excess reserves, and recourse at the deposit facility

Borrowing in Spain and Italy is expensive — let’s securitize it away

One of the main problems for Europe is the broken transmission mechanism. It’s been a problem for quite some time.

When the ECB cut its rate, it won’t pass through to the areas of Europe that need it: the periphery. There is thus a world in which it is easy to get cheap credit (the core) and a world in which it is expensive (the periphery) — no matter how low the refi rate is.

With that in mind, here’s a Goldman Sachs graph from an excellent note by Huw Piil:

Lending rates in Europe GS Borrowing in Spain and Italy is expensive    lets securitize it away

Here’s Goldman’s explanation of the graph (their emphasis):

Exhibit 1 illustrates the latest data, demonstrating the persistence of the gap between lending rates in the ‘core’ countries (Germany and France) that remain well integrated into Euro financial markets and the ‘peripheral’ countries (Spain and Italy). Indeed, in the January data, this specific measure points to a widening of the gap, despite the success of the ECB’s OMT programme in stabilising government debt markets and narrowing sovereign spreads.

Taking a somewhat longer perspective, it is apparent that the ECB’s easing actions over the past 18 months (the rate cuts in November 2011 and July 2012; the implementation of 3-year LTROs in December 2011 and February 2012; and the announcement of the OMT in September 2012) have passed through to lower bank lending rates in Germany and France, whereas, at best, these measures have only served contain the rise in bank lending rates in Spain and Italy.

The problem summarised by Piil:

Given the weak macroeconomic situation in the periphery, there is a concern that monetary stimulus is not being transmitted to the countries where it is most needed — this is the essence of the impairment to monetary policy transmission that so consumes ECB policymakers. And there is an important sectoral dimension to this impairment, in addition to the cross-country element that has been emphasised thus far: larger companies with access to capital markets are able to issue debt at narrow spreads to sovereigns (and therefore now at reasonable rates even in the periphery), but SMEs are dependent on banks and thus face the elevated rates shown in Exhibit 1. These two dimensions interact and amplify each other: the Spanish and Italian corporate sectors are both dominated by the SME sector.

There are thus two reasons: 1) peripheral countries are more risky and banks (and companies) are increasingly trying to match assets and liabilities on a state-line instead of on a euro zone basis, and 2) the sectoral composition of companies who need credit, where the peripheral have more SMEs without access to capital markets.

So how to ease? As Piil suggests, the ECB could use its collateral framework to support financial innovation. By now, most will probably react like this guy when they hear ‘financial innovation’, but the idea is quite good.

By relaxing the collateral the ECB accepts to include asset-backed securities where the underlying is loans from SMEs in the peripheral, the securitization could start to work.

If the loans could be packed into ABS that could be pledged at the ECB as collateral, it might increase the amount of lending in the peripheral at rates closer to the core. Obviously haircuts would have to be low enough to make it worthwhile, but not so low as to make Weidmann go crazy.

To make ABS backed by peripheral SME loans eligible as collateral might be a way for the ECB to alleviate the problems of structural differences across the monetary zone.

For reference, here’s the ECB’s website on collateral eligibility; and their website on their newly established ABS loan-level initiative.

Market not ready for Polish rate cut

So the Polish central bank cut its reference rate by 50bps. And it was unexpected.

Pawel Morski on twitter had a great catch:

Bloomie Market not ready for Polish rate cut

Showing that absolutely none of the economist pooled by Bloomberg had a 50bps cut forecast. 25bps cut wasn’t even a sure deal (although likely.) Funny.