Credit crunch – John Barrdear

25 January 201226 February 2013

Terrible news from Apple (AAPL)

Apple just reported their profits for 2011Q4. It turns out that they made rather a lot of money. So much, in fact, that they blew past/crushed/smashed expectations as their profit more than doubled on the back of tremendous growth in sales of iPhones and iPads. [snark] I’ll bet nobody’s talking about Tim Cook being gay now. [/snark]

It’s an incredible result; stunning, really. I just wish it didn’t make me so depressed.

I salute the innovation and cheer on the profits. That is capitalism at its finest and we need more of it.

It’s that f***king mountain of cash (now up to $100 billion) that concerns me, because it’s symptomatic of what is holding America (and Britain) in the economic doldrums.

The return Apple will be getting on that cash will be miniscule, if it’s positive at all, and conceivably negative. Standing next to that, their return on assets excluding cash is phenomenal.

Why aren’t they doing something with the cash? Are they not able to expand profits still further by expanding quantities sold, even in new markets? Are there no new internal projects to fund? No competitors to buy out? Why not return it to shareholders via dividends or share buybacks?

Logically, a company holds cash for some combination of three reasons: (a) they use it to manage cash flow; (b) they can imagine buying an outside asset (a competitor or some other company that might complement them) in the near future and they want to be able to move quickly (and there’s no M&A deal that’s agreed upon faster than an all cash deal); or (c) they want to demonstrate a degree of security to offset any market perceived risk with their debt.

Apple long ago surpassed all of these benefits. The net marginal value of Apple holding an extra dollar of cash is negative because it returns nothing and incurs a lost opportunity cost. So why aren’t their shareholders screaming at them for wasting the opportunity?

The answer, so far as I can see, is because a significant majority of AAPL’s shareholders are idiots with a short-term focus. They have no goddamn clue where else the money should be and they’re just happy to see such a bright spot in their portfolio. Alternatively, maybe the shareholders aren’t complete idiots — Apple’s P/E ratio has been falling for a while now — but the fundamental point is that they have a mountain of cash that they’re not using.

In 2005 that wouldn’t have been as much of a problem because the shadow banking system was in full swing, doing the risk/liquidity/maturity transformation thing that the financial industry is meant to do and so getting that money out to the rest of the economy.[*] Now, the transformation channel is broken, or at least greatly impaired, and so nobody makes any use of Apple’s billions. They just sit there, useless as f***, while profitable SMEs can’t raise funds to expand and 15% of all Americans are on food stamps.

Don’t believe me? Here’s a graph from the Bank of England showing year-over-year changes in lending to small- and medium-sized enterprises in the UK. I can’t be bothered looking for the equivalent data for the USA, but you can rest assured it looks similar. The report it’s from can be found here (it was published only a few days ago). The Economist’s Free Exchange has some commentary on it here (summary: we’re still in trouble).

So what is happening to all that money? Well, Apple can’t exactly stick it in a bank account, so they repo it, which is a fancy way of saying that they lend it to a bank (or somebody else in the financial industry) and temporarily take some high quality asset like a US government bond to hold as collateral. They repo it because that’s all they can do now — there are no AAA-rated, actually safe, CDO tranches being created by the shadow banking system any more, they’re too big to make use the FDIC’s guarantee (that’s an excellent paper, btw … highly recommended) and so repo is all they have left.

But the financial industry is stuck in a disgusting mess like some kid’s hair with chewing gum rubbed through it. They’re all just as scared as the next guy (especially of the Euro problems) and so they’re parking it in their own accounts at the Fed and the BoE. As a result, “excess” reserves remain at astronomical levels and the real economy makes no use of Apple’s billions.

That’s a tragedy.

[*] Yes, the shadow banking industry screwed up. They got caught up in real estate fever and sent (relatively) too much money towards property and too little towards more sustainable investments. They structured things in too opaque a manner, failed to have public price discovery and operated under distorted incentives. But they operated. Otherwise useless cash was transformed into real investment and real jobs. Unless that comes back, America and the UK will stay in their slow, painful household deleveraging cycle for another frickin’ decade.

30 November 201130 November 2011

Policy options for the Euro area [Updated]

I here list a few policy options for the Euro area that I support, broadly in descending order of my perception of their importance. Everything here is predicated on an assumption that the Euro itself is to survive and that no member nation of the Euro area is to exit the union. I don’t claim that this would solve the crisis — who would make such a claim? — but they would all be positive steps that increase the probability of an ultimate solution being found.

Immediately establish a single, Euro area-wide bank deposit guarantee scheme. A single currency must absolutely ensure that a Euro held as money in Greece be the same as a Euro held as money in Germany. That means that retail and commercial deposits in each should be backed by the same guarantee. I have no firm opinion on how it should be funded. The classic manner is through a fee on banks proportional to their deposits, but if Euro area countries ultimately prefer to use a Tobin-style tax on transactions, that’s up to them. Just get the thing up and running. Of course, a unified deposit guarantee also requires a unified resolution authority in the event of an insolvent bank collapsing. There are many and varied forms that fiscal union can take; this is the most urgent of them all. I am shocked that this does not already exist.

The ECB should switch from targetting current inflation to expected future inflation. The Bank of England already does this. Accepting that any effect of monetary policy on inflation will come through with a lag (or at least acknowledging that current inflation is backward looking), they “look through” current inflation to what they expect it to be over the coming few years. This is important. Current inflation in the Euro area — i.e. the rate of change over the last 12 months — is at 3%. On the face of it, that might make an ECB policymaker nervous, but looking ahead, market forecasts for average inflation over the coming five years are as low as 0.85% per year in Germany. They will be much lower for the rest of the Euro area. Monetary policy in the Euro area is much, much too tight at the moment. At the very least, (a) interest rates should be lowered; and (b) the ECB should announce their shift in focus toward forward inflation.

The ECB should start to speak more, publicly, about forms of current inflation that most affect future inflation. This follows on from my previous point, but is still logically distinct. The Fed likes to focus on “core” inflation, stripped of items with particularly volatile price movements. I don’t much care whether it is non-volatile prices or nominal wages, or even nominal GDP. I just want the ECB to be speaking more about something other than headline CPI, because it is those other things that feed into future headlines.

The ECB’s provision of liquidity to the banking system, while currently large, is not nearly large enough. The fact that “German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate” is clear evidence of this. I currently have no opinion on whether this ought to be in the form of increasing the duration of loans to Euro area banks, relaxing the collateral requirements for loans or working with member countries’ treasuries to increase the provision of collateral. I certainly believe (see my second point above) that interest rates should be lowered. The point, as far as is possible, is to make replacing lost market funding with ECB funding more attractive to banks than deleveraging.

A great deal of Euro area sovereign debt is unsustainable; hair-cuts are inevitable and they should be imposed as soon as possible (but, really, this requires that a unified bank resolution authority be established first). The argument for delaying relies on banks’ ability to first build up a cushion of capital through ongoing profitability. When banks are instead deleveraging, the problem is made worse by waiting.

Credit Default Swaps must be permitted to trigger. The crisis may have its origins in the the profligacy of wayward sovereigns (frankly, I think the origins lie in the Euro framers not appreciating the power of incentives), but the fundamental aspect of the crisis itself is that various financial assets, previously regarded as safe, are coming to be thought of as risky. By denying market participants the opportunity to obtain insurance, Euro area policymakers are making the problem worse, not better. Market willingness to lend to Greece in 2025 will in no way depend on how we label the decisions made in 2011 and 2012.

Every member of the Euro periphery should be in an IMF programme. Yes, I’m looking at you, Italy. If the IMF does not have sufficient funds to work with, the ECB should lend to it. All politicians in Euro periphery countries should be speaking to their electorates about multi-decade efforts to improve productivity. These things cannot be fixed in two or three years. They can, at best, be put on the right path.

For every country in an IMF programme, all sovereign debt held by the ECB should be written down to the price at which they purchase it. If the ECB buys a Greek government bond at, say, a 20% discount to face value, then that bond should be written down by 20%. The ECB should not be in a position to make a profit from their trading if Europe finds its way through the overall crisis. Similarly, the ECB should not be in a position to take a loss, either — they should not be required to take a hair-cut below the price they pay for Euro area sovereign debt.

Note that I have not yet used the phrase “Euro bond” anywhere. Note, too, that a central bank is only meant to be a lender of last resort to banks. The lender of last resort to governments is the IMF.

If Euro area policymakers really want to engage in a fiscal union (a.k.a. transfers) beyond the absolutely essential creation of a unified bank deposit guarantee scheme, it is perfectly possible to do so in a minimal fashion that does not lessen the sovereignty of any member nation: Have a newly created European Fiscal Authority (with voluntary membership) provide the minimum universally agreed-on level of unemployment benefits across the entire area, funded with a flat VAT. Any member country would retain the ability to provide benefits above and beyond the minimum. This will have several benefits:

Since its membership would be voluntary and it would provide only the minimum universally agreed level, it cannot, by definition, constitute a practical infraction on sovereignty;
It will help provide pan-European automatic stabilisers in fiscal policy;
It will provide crucial intra-European stabilisation;
It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high; and
It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.

———————-

Update 30 Nov 2011, 13:05 (25 minutes after first publishing the post):

It would appear that the world’s major central banks have announced a coordinated improvement in the provision of liquidity to banks. This is a good thing. Press releases:

2 September 20093 September 2009

An information-based approach to understanding why America let Lehman Brothers collapse but saved everyone afterwards

In addition to his previous comments on the bailouts [25 Aug, 27 Aug, 28 Aug], which I highlighted here, Tyler Cowen has added a fourth post [2 Sep]:

I side with Bernanke because an economy can withstand only so much major bank insolvency at once. Lots of major banks were levered up 30-1 or so. Their assets fell in value more than a modest amount and then they were insolvent, sometimes grossly so. (A three percent decline in asset values already puts you into insolvency range.) If AIG had gone into bankruptcy court, some major banks would have been even more insolvent. Or if Frannie securities had been allowed to find their non-bailout values. My guess is that at least 15 out of the top 20 U.S. banks would have been flat-out insolvent if, starting at the time of Bear Stearns, all we had done was loose monetary policy and no other bailouts. Subsequent contagion effects, and the shut down of short-term repo markets, and a run on money market funds, would have made even more financial institutions insolvent. The world as we know it then becomes very dire, both for credit reasons and deflation reasons (yes you can print up currency to keep measured M up and running but the economy still collapses). So we needed not just emergency lending but also resource transfers to banks, basically to put them back into the range of possible solvency.

I really like to see Tyler’s evolving attitudes here. It lets me know that mere grad students are allowed to not be sure of themselves. 🙂 In any event, let me present my latest thoughts on the bailouts:

Imagine being Bernanke/Paulson two days before Lehman Brothers went down: you know they’re going to go down if you don’t bail them out and you know that to bail them out creates moral hazard problems (i.e. increases the likelihood of a repeat of the entire mess in another 10 years). You don’t know how close to the edge everyone else is, nor how large an effect a Lehman collapse will have on everyone else in the short-run (thanks, in no small part, to the fact that all those derivatives were sold over-the-counter), but you’re nevertheless almost certain that Lehman Brothers are not important enough to take down the whole planet.

In that situation, I think of the decision to let Lehman Brothers go down as an experiment to allow estimation of the system’s interconnectedness. Suppose you’ve got a structural model of the U.S. financial system as a whole, but no empirical basis for calibrating it. Normally you might estimate the deep parameters from micro models, but when derivatives were exempted from regulation in the 2000 Commodities Futures Modernization Act, in addition to letting firms do what they wanted with derivatives you also gave up having information about what they were doing. So instead, what you need is a macro shock that you can fully identify so that at least you can pull out the reduced-form parameters. Letting Lehman go was the perfect opportunity for that shock.

I’m not saying that Bernanke had an actual model that he wanted to calibrate (although if he didn’t, I really hope he has one now), but he will certainly have had a mental model. I don’t even mean to suggest that this was the reasoning behind letting Lehman go. That would be one hell of a (semi) natural experiment and a pretty reckless way to gather the information. Nevertheless, the information gained is tremendously valuable, both in itself and to society as a whole because it is now, at least in part, public information.

To some extent, I feel like the ideal overall response to the crisis from the Fed and Treasury would have been to let everyone fail a little bit, but that isn’t possible — you can’t let an institution become a little bit bankrupt in the same way that you can’t be just a little bit pregnant. To me, the best real-world alternative was to let one or two institutions die to put the frighteners on everyone and discover the degree of interconnectedness of the system and then save the rest, with the nature and scale of the subsequent bailouts being determined by the reaction to the first couple going down. I would only really throw criticism at the manner of the saving of the rest (especially the secrecy) and even then I would be hesitant because:

(a) it was all terribly political and at that point the last thing Bernanke needed was a financially-illiterate representative pushing his or her reelection-centred agenda every step of the way (we don’t let people into a hospital emergency room when the doctor isn’t yet sure of what’s wrong with the patient);

(b) perhaps the calibration afforded by the collapse of Lehman Brothers convinced Bernanke-the-physician that short-term secrecy was necessay to “stop the bleeding” (although that doesn’t necessarily imply that long-term secrecy is warranted); and

20 August 2007

Conspiracy theories and the current market turmoil

A friend pointed me to this conspiracy theory video. I’ve not watched more than 30 seconds of this particular video, but according to discussion on the RANDI forums, I understand that it splices footage directly from a number of other conspiracy theory films into one, with all the greatest hits of the anti-establishment anarchist left being given a run (christians and/or jews are evil and secretly rule the world, 9/11 was a government inside job, the entire global banking system is a sham and run by bad people, etc).

Of more interest to me is this question, put to me by my friend:

Why are more and more of these conspiracy theories coming out in video format only, with no transcriptions?

Perhaps it’s to appeal to a wider audience (i.e. more people are willing to watch a movie than read the equivalent text). Perhaps it’s because a movie can more readily achieve an intense, even emotional, impact than abstract text. Perhaps it’s just another example of market demand and supply …

The real (as in true) explanations for what goes on tend to be considerably more complex and almost infinitely more tedious than those offered by conspiracy theorists. People seem to want answers, but aren’t willing to accept that they might be anything other than simple and exciting. Maybe that’s a result of today’s media culture of soundbite-driven news and action movies, but maybe it’s just an unfortunate consequence of otherwise rational ignorance. You can’t be an expert in everything (strictly speaking, it’s too costly), so you don’t waste your time trying and instead trust the summaries given by people you take to be experts.

As an example of the demand for simplified summaries, consider the recent turmoil on the world’s credit- and stock-markets. I have spoken to several people about the happenings and most of them aren’t the least bit interested in understanding the details of what’s going on. Instead, they only want to know if (a) the world is going to end (i.e. they’re going to lose their job or their pension savings are going to collapse) or (b) if it’s all been caused by evil, money-grubbing people deliberately destabilising the world for their private profit.

By my thinking, to really understand the current turmoil (I still refuse to call it a crisis), you need to understand the basics of:

How bonds work
The difference between long-term and short-term bonds
The difference between government and commercial securities
The fact that central banks announce a target interest rate rather than fixing it by fiat
Reserve requirements
Overnight inter-bank lending
How banks view loans to consumers (i.e. as assets)
Structured finance in general
CDOs in particular
Derivatives
Hedging and hedge funds
The difference between credit markets, stock markets and foreign exchange markets and how movements in each might affect the others
The carry trade

And that’s before you start considering the psychology of the people involved and all the resulting work in behavioural finance. Unless you’re seriously (and usually, professionally) interested in investment, finance or economics, why would you care about all of those details? You wouldn’t … you just want to know if the world is going to end and if there’s somebody to blame.

On the supply side of these nuggets of information, you have … well, you’re looking at one. Commentators, both professional (in the mainstream media) and self-appointed (in your local pub and all over the internet) are competing to convince you that they are experts in the topic at hand and having managed that, to provide you with their summarised opinions.

Suppose, however, that for some reason you can’t properly identify who is a real expert or you have some reason to distrust the experts you can identify. In that case, you’re left taking in the simplified views of non-expert subject-matter aficionados, of which a small but statistically-significant fraction are going to be conspiracy theorists. Insofar as they want to expand their customer base, conspiracy theorists (who, to be frank, are often less troubled by the truth than they are with attracting an audience) will experiment with their provision of service to best meet the demand for simple and exciting explanations. Thus, we have movies with no (tedious) transcripts.