Agustin Mackinlay
a.mackinlay@euruni.edu
Session 5 - February 28, 2012
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· A word on the TED spread**
· Credit markets***, Flight-to-quality****, Funding***, Central bank liquidity operations***, Eurodollar futures***: a review
A word on the TED spread**
. Mark Gonglof: “TED Spread Hits Highest Level Since Crisis”, Wall Street JournalThe Ted spread [chart] is a difference between two short-term interest rates. It is watched anxiously (in times of Flight-to-Safety) by bank managers. The TED spread is the difference between the three-month LIBOR rate and the yield of the three-month Treasury bill. It is currently at about 36 basis points:
TEDspread = 0.45% [LIBOR RATE] – 0.09% [TREASURY BILL RATE] = 0.36%
The TED spread is a measure of the overall confidence in the banking system. When confidence is high, the TED spread is low: banks have little or no funding problems, and depositors feel that their more money is safe. During a F-t-Q episode, however, funding problems arise; LIBOR rates go up as depositors demand higher deposit rates and banks do not trust each other in the money market; this pushes LIBOR higher (less supply of credit). At the same time, savers worry about the return of their money, no about the return on their money. The park money in short-term Treasury Bills, widely considered one of the safest and most liquid assets in the world. This pushes T-Bill rates down (more supply of credit).
[QUESTION: HOW WOULD YOU PLAY THE TED SPREAD IN THE FUTURES MARKET, ASSUMING THAT THE T-BILL FUTURES ARE STRUCTURED JUST AS THE EURODOLLAR FUTURES?]
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Credit markets***, Flight-to-quality****, Funding***, Central bank liquidity operations***, Eurodollar futures***. A ‘dynamic’ review of the issues
[1] The Role of the Dollar. Understanding the banking crisis: a (brief) look at the US dollar as the key international reserve currency. 1945-1973: Germany & Japan; 1978-2007: China. The stock of productive capital destroyed; authoritarian political culture. The solution: LOW COST OF LABOUR through a fixed (and undervalued) local currency exchange rate against the dollar.
[2] China’s economic development model. In order to avoid an exchange rate adjustment, China recycles its foreign-exchange reserves into the US credit market. [QUESTION: IMPACT ON THE US CREDIT MARKET??][CHART] [Annex to the Federal Reserve’s Weekly Balance Sheet]. Michael P. Dooley, David Folkerts-Landau & Peter Garber: “An Essay on the Revived Bretton Woods System”, NBER Working Paper 9971 (2003).
[3] Psychology & Markets: Attitudes toward risk. US credit markets flooded with cash! Jacques Rueff. Le péché monétaire de l’Occident. Paris: Plon, 1971: “The process works this way. When the U.S. has an unfavorable balance with another country (let us take as an example France), it settles up in dollars. The Frenchmen who receive these dollars sell them to the central bank, the Banque de France, taking their own national money, francs, in exchange. The Banque de France, in effect, creates these francs against the dollars. But then it turns around and invests the dollars back into the U.S. Thus the very same dollars expand the credit system of France, while still underpinning the credit system in the U.S. The country with a key currency is thus in the deceptively euphoric position of never having to pay off its international debts. The money it pays to foreign creditors comes right back home, like a boomerang … The functioning of the international monetary system is thus reduced to a childish game in which, after each round, the winners return their marbles to the losers … The discovery of that secret [namely, that no adjustment takes place] has a profound impact on the psychology of nations (la psychologie des peuples) … This is the marvelous secret of the deficit without tears, which somehow gives some people the (false) impression that they can give without taking, lend without borrowing, and purchase without paying. This situation is the result of a collective error of historic proportions”
[4] Psychology & Markets: Attitudes toward risk
F = 2.5 x G !!!
Some references on emotions, the economy, credit markets:
Some references on emotions, the economy, credit markets:
. Akerlof, George A. & Schiller, Robert A. Animal Spirits. How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism (Princeton University Press, 2009) [see]
. Gasparino, Charles. The Sellout. How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System (New York: HarperBusiness, 2009) [see]. From a Financial Times review: “Gasparino narrates convincingly how banks such as Bear [Stearns] slipped into risking ever more capital, often without the full understanding of their leaders, who were engaged in a contest to see who could catch up with Goldman Sachs”. The same, by the way, could be said about Swiss bank UBS.
. Tett, Gillian: “The emotional markets hypothesis and Greek bonds”, Financial Times, April 10/11 2010.
. Turner Review. A regulatory response to the global banking crisis (London: Financial Services Authority, 2009). See p. 41: “Individual behaviour is not entirely rational. There are moreover insights from behavioural economics, cognitive psychology and neuroscience, which reveal that people often do not make decisions in the rational front of brain way assumed in neoclassical economics, but make decisions which are rooted in the instinctive part of the brain, and which at the collective level are bound to produce herd effects and thus irrational momentum swings”.
. J. M. Coates & J. Herbert: “Endogenous steroids and financial risk taking on a London trading floor”, Proceedings of the National Academy of Sciences, April 2008 [Judge Business School, University of Cambridge, Cambridge CB2 1AG, United Kingdom ; Cambridge Center for Brain Repair, University of Cambridge, Cambridge CB2 0PY, United Kingdom]. Edited by Bruce S. McEwen, The Rockefeller University, New York, NY, and approved November 6, 2007 (received for review May 1, 2007)
Abstract
Little is known about the role of the endocrine system in financial risk taking. Here, we report the findings of a study in which we sampled, under real working conditions, endogenous steroids from a group of male traders in the City of London. We found that a trader's morning testosterone level predicts his day's profitability. We also found that a trader's cortisol rises with both the variance of his trading results and the volatility of the market. Our results suggest that higher testosterone may contribute to economic return, whereas cortisol is increased by risk. Our results point to a further possibility: testosterone and cortisol are known to have cognitive and behavioral effects, so if the acutely elevated steroids we observed were to persist or increase as volatility rises, they may shift risk preferences and even affect a trader's ability to engage in rational choice.
. Roger Boyes: "Age of Testosterone comes to end in Iceland", TimesOnline (February 7, 2009). Iceland, ravaged throughout history by volcanic eruptions and natural catastrophes, is struggling with a man-made disaster so overwhelming that the women are taking over. It is, they say here, the end of the Age of Testosterone. Next week a newly minted left-leaning Government led by Johanna Sigurdardottir will start to tackle the tough agenda of cleaning out the old-school-chum networks that have led Iceland to the verge of bankruptcy. Half of her Cabinet will be women; female advisers carrying briefcases move in and out of the Prime Minister's whitewashed office, a former jailhouse in the middle of Reykjavik. Two women, Birna Einarsdottir and Elin Sigfusdottir, now run the struggling and disgraced New Landsbanki and New Glitnir banks. We have to create a new sense of solidarity,” says the Social Democrat Prime Minister. The departing Government — retreating would be more precise — put business first, people second, say the premier's counsellors. Now is the time for a shift in values. Listening to Ms Sigurdardottir talk in her dry, schoolmistress manner, it becomes clear that the fall of the Icelandic Government was not just the first political casualty of the global downturn, but also a signal that men in suits have led the world astray. “We are going to base our economic policies on prudence and responsibility, but we also stress social values, women's rights, equality and justice,” she says. “You can see what is happening,” says Katrin Olafsdottir, Associate Professor of Economics and a member of the board of New Glitnir, which is trying to devise a new mission for the crippled bank. “The men went out there and took these incredibly irrational risks — and getting loads of money for doing it, feeling really good about it - and then the women have to come in to clean it up.”
. Gasparino, Charles. The Sellout. How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System (New York: HarperBusiness, 2009) [see]. From a Financial Times review: “Gasparino narrates convincingly how banks such as Bear [Stearns] slipped into risking ever more capital, often without the full understanding of their leaders, who were engaged in a contest to see who could catch up with Goldman Sachs”. The same, by the way, could be said about Swiss bank UBS.
. Tett, Gillian: “The emotional markets hypothesis and Greek bonds”, Financial Times, April 10/11 2010.
. Turner Review. A regulatory response to the global banking crisis (London: Financial Services Authority, 2009). See p. 41: “Individual behaviour is not entirely rational. There are moreover insights from behavioural economics, cognitive psychology and neuroscience, which reveal that people often do not make decisions in the rational front of brain way assumed in neoclassical economics, but make decisions which are rooted in the instinctive part of the brain, and which at the collective level are bound to produce herd effects and thus irrational momentum swings”.
. J. M. Coates & J. Herbert: “Endogenous steroids and financial risk taking on a London trading floor”, Proceedings of the National Academy of Sciences, April 2008 [Judge Business School, University of Cambridge, Cambridge CB2 1AG, United Kingdom ; Cambridge Center for Brain Repair, University of Cambridge, Cambridge CB2 0PY, United Kingdom]. Edited by Bruce S. McEwen, The Rockefeller University, New York, NY, and approved November 6, 2007 (received for review May 1, 2007)
Abstract
Little is known about the role of the endocrine system in financial risk taking. Here, we report the findings of a study in which we sampled, under real working conditions, endogenous steroids from a group of male traders in the City of London. We found that a trader's morning testosterone level predicts his day's profitability. We also found that a trader's cortisol rises with both the variance of his trading results and the volatility of the market. Our results suggest that higher testosterone may contribute to economic return, whereas cortisol is increased by risk. Our results point to a further possibility: testosterone and cortisol are known to have cognitive and behavioral effects, so if the acutely elevated steroids we observed were to persist or increase as volatility rises, they may shift risk preferences and even affect a trader's ability to engage in rational choice.
. Roger Boyes: "Age of Testosterone comes to end in Iceland", TimesOnline (February 7, 2009). Iceland, ravaged throughout history by volcanic eruptions and natural catastrophes, is struggling with a man-made disaster so overwhelming that the women are taking over. It is, they say here, the end of the Age of Testosterone. Next week a newly minted left-leaning Government led by Johanna Sigurdardottir will start to tackle the tough agenda of cleaning out the old-school-chum networks that have led Iceland to the verge of bankruptcy. Half of her Cabinet will be women; female advisers carrying briefcases move in and out of the Prime Minister's whitewashed office, a former jailhouse in the middle of Reykjavik. Two women, Birna Einarsdottir and Elin Sigfusdottir, now run the struggling and disgraced New Landsbanki and New Glitnir banks. We have to create a new sense of solidarity,” says the Social Democrat Prime Minister. The departing Government — retreating would be more precise — put business first, people second, say the premier's counsellors. Now is the time for a shift in values. Listening to Ms Sigurdardottir talk in her dry, schoolmistress manner, it becomes clear that the fall of the Icelandic Government was not just the first political casualty of the global downturn, but also a signal that men in suits have led the world astray. “We are going to base our economic policies on prudence and responsibility, but we also stress social values, women's rights, equality and justice,” she says. “You can see what is happening,” says Katrin Olafsdottir, Associate Professor of Economics and a member of the board of New Glitnir, which is trying to devise a new mission for the crippled bank. “The men went out there and took these incredibly irrational risks — and getting loads of money for doing it, feeling really good about it - and then the women have to come in to clean it up.”
[5] Vulnerabilities, 2007-2008
. Tim Geithner: “A Disaster Far Beyond Lehman Brothers Collapse”, Banking & Finance News, 20 April 2010.
. Raghuram J. Rajan. Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press, 2010) [web page] [Introduction] [video]
. Ann O’Ryna Spehar: “The Great Moderation and the Business Cycle”, MPRA Paper No. 12274, December 2008.
The size of the SHADOW BANKING SYSTEM. By 2007, the US banking system had seen enormous change. Instead of focusing on old-fashioned banking and holding mortgage loans on their books, many banks became like sausage factories: originate mortgages, then sell them to investors and to … their own off-balance investment vehicles. US Treasury Secretary Tim Geithner: “In the run-up to the recent crisis, we witnessed a period of explosive growth in leverage and maturity transformation outside the perimeter of prudential banking regulation. This parallel, lightly regulated system has come to be known as the “shadow banking system.” Large dealer firms like Lehman were a key part of this system–but they were just one part. At its peak, the shadow banking system financed about $8 trillion in assets with short-term obligations, making it almost as large as the real banking system”.The rate of home ownership almost reaches 70% in 2006.
Why and how? WHY? (1) to achieve hedge fund link returns through leverage; (2) to get big bonuses!; (3) to achieve too-big-to-fail status.
The Asset / Liability Mismatch problem. While it is a natural occurrence in banking, it took unusual proportion during the 2002-2007 years. Largely driven by THE BELIEF THAT INTEREST RATES WERE STAYING LOW FOREVER, Special Investment Vehicles belonging to banks bought long-term, high-yielding subprime mortgage-backed securities with short-term debt instruments from money market funds. Some banks achieved 30-1 leverage ratios! It proved very profitable between 2003 and 2006.
. Sources of risk. We can see 2 sources of risk: (a) a fall in the value of the assets (mortgage-backed securities); (b) a rise in the cost of short-term credit. By 2007, banks were financing mortgage-backed securities with very short-term debt – based on the belief that interest rates would stay low.
. Fed raises short-term interest rates. Starting in mid-2004, the Federal Reserve raises its target rate for the interest rate at which banks lend to each other, from 1% (following the terrorist attacks of 2001) to 5.25%, because of fears of rising inflation expectations.[CHART]
. Disaster strikes in early and mid-2007. DEFAULT RATES GO UP in the subprime mortgage loan market! They reach 20%, as the job market deteriorates. The news sends the market in turmoil. WHAT ARE THE ALTERNATIVES AT THAT STAGE? [Simulation: sell assets / raise capital / take losses and close down operations / take SIVs back into the balance sheet of the bank].
Assets CITIGROUP : SIVs & CONDUITS Liabilities & Capital
. Mortgage-backed securities: $ 156 billion ( high interest rate: 12%, but very long-term) | |
. Short-term credit: $ 144 billion ( low interest rate: 3%, but very short-term) | |
. Capital: $ 12 billion |
Assets CITIGROUP : SIVs & CONDUITS Liabilities
THE VALUE OF THE ASSETS (SUBPRIME MORTGAGE-BACKED SECURITIES) IS …. COLLAPSING! (1) | THE COST OF FINANCING THE ASSETS (SUBPRIME MORTGAGE-BACKED SECURITIES) IS …. SOARING! (2) |
(1) Because rising unemployment has suddenly created a wave of defaults amid subprime mortgage borrowers!
(2) Because the Federal Reserve –fearing the prospect of higher inflation rates– has been increasing the target rate for the rate at which banks lend to each other.
[6] The Lehman Brothers collapse, September 15 2008
Lehman Brothers, one of the oldest Wall Street investment banks, was holding as much as $327 billion in assets (including subprime mortgage-backed securities), of which at least $50 billion in subprime mortgage-backed securities had been hidden from view. By September 2008, its losses were of such magnitude that it had not enough capital to cover them. The day it is finally declared bankrupt (September 15), it was owing $613 billion in debt. Panic in money markets!
Panic in interbank lending markets!
[7] FLIGHT-TO-QUALITY!****
See blog post for Session 2:
[8] TED spread soars!***
Banks in the US and Europe are having serious funding problems. Witness: the TED spread.
[9] Central banks ease monetary policy
. Federal Reserve: Credit and Liquidity Programs and the Balance Sheet
As demand for credit declines, the rate at which banks lend to each other starts to decrease. Central banks have two possibilities. Either they announce a new (LOWER) target rate, or the sell bonds to commercial banks in order to drain liquidity [CHART] [ECB target rates].
See Session 3.
Nicolas Sarkozy and the ECB.
[10] First round of Central banks liquidity swaps***
. Federal Reserve: Central Bank Liquidity Swaps
To prevent the flight-to-quality to spread further, central banks launch the first series of highly successful CENTRAL BANK LIQUIDITY SWAPS.
See session 4.
No central bank liquidity swaps for Ms. Tymoshenko’s Ukraine!
[11] The Federal Reserve implements Quantitative Easing (QE)
. Federal Reserve: Central Bank Liquidity Swaps
The target rate for overnight loans between banks is lowered to … zero. Reserves of commercial banks at the Federal Reserve reach US$1 trillion. [CHART].
[DIAGRAM]
[12] Greece cooks the books: a new round of Flight-to-Quality. Assets & Liabilities at European banks***
As the Greek government informs that it had ‘cooked the books’, a new round of F-t-Q begins. This time, the epicenter is … Europe. The process goes on, with ups and downs, from 2009 to 2011. All indicators of F-t-Q start to flash: credit spreads, banks’ stock prices, the TED spread.
[HOW DOES IT AFFECT EUROPEAN BANKS? THINK IN TERMS OF ASSETS, LIABILITIES ]
See session 4.
[13] November 30, 2011. Second round of Central Bank Liquidity Swaps. European banks need funding in US$ dollars!***
ECB announcement.
See session 4.
[14] December 22, 2011. The European Central Bank announces first tranche of Long-Term Refinancing Operations***
See session 3.
Show me the money! [video].
[15] February 29, 2012. The European Central Bank announces second tranche of Long-Term Refinancing Operations
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