Wednesday, October 29, 2008
Central Banks Have Become Market Destroyers 10-28-2008
The market was more honest than most paid pundits and special interest policymakers. Market participants knew the crisis was not merely a passing liquidity crunch, but a widespread insolvency created by excessive asset value unsupported by compensatory revenue. Insolvency will translate into sharp declines in asset price. The government can destroy the market in the name of saving it but the laws of market cannot be negated by government intervention.
The recent opening of the Federal Reserve discount window to borrowings by commercial banks, collateralized by illiquid assets, and the extension of discount window access to investment banks have pushed the central bank across the line of being a lender of last resort to being a market destroyer. It is no wonder that its liquidity injection moves have failed to moderate seizure of global credit markets. This is because the central bank, not constrained by the supply and market value of money, can set the price of illiquid asset by fiat, thus destroy the very function of the market in setting meaningful prices that can defuse market seizure. Central bank intervention into credit markets to artificially support asset prices above market levels carries no fundamental market implication, save the impact of future inflation. The market knows that asset prices assigned by the central bank are not real and will be adjusted downward as soon as central bank intervention ends. And until central bank intervention ends, the market remains in suspension.
The recent opening of the Federal Reserve discount window to borrowings by commercial banks, collateralized by illiquid assets, and the extension of discount window access to investment banks have pushed the central bank across the line of being a lender of last resort to being a market destroyer. It is no wonder that its liquidity injection moves have failed to moderate seizure of global credit markets. This is because the central bank, not constrained by the supply and market value of money, can set the price of illiquid asset by fiat, thus destroy the very function of the market in setting meaningful prices that can defuse market seizure. Central bank intervention into credit markets to artificially support asset prices above market levels carries no fundamental market implication, save the impact of future inflation. The market knows that asset prices assigned by the central bank are not real and will be adjusted downward as soon as central bank intervention ends. And until central bank intervention ends, the market remains in suspension.
Leverage and Deleverage 10302008
The Impact of Leverage and De-leverage on Asset Price
The net capital rule created by the SEC in 1975 required broker-dealers to limit their debt-to-net-capital ratio to 12-to-1, and they must issue early warnings if they began approaching this limit, and were forced to stop trading if they exceeded it, so broker-dealers often kept their debt-to-net capital ratios much lower than 12-1. The rule allowed the SEC to oversee broker-dealers, and required firms to value all of their tradable assets at market prices. The rule applied a haircut, or a discount, to account for the assets’ market risk. Equities, for example, had a haircut of 15%, while a 30-year Treasury bill, because it is less risky, had a 6% haircut. But a 2004 SEC exemption -- given only to five big firms -- allowed them to lever up 30 and even 40 to 1.
The five big firms wanted for their brokerage units an exemption from the 1975 regulation that limited the amount of debt they could take on to $12 for every dollar of equity. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those equity funds could then flow up to the parent company, enabling it to invest in the fast growing but opaque world of mortgage-backed securities, credit derivatives, credit default swaps - a form of insurance for bond holders - and other exotic structured finance instruments
In 2004, the European Union passed a rule allowing the SEC’s European counterpart to manage the risk both of broker dealers and their investment banking holding companies. In response, the SEC instituted a similar, voluntary program for broker-dealers with capital of at least $5 billion, enabling the agency to oversee both the broker-dealers and the holding companies. Ever since the Great Depression, the government has tried to limit the leverage available to the public in the US stock market by maintain margin requirements. But regulators, led by former chairman of the Federal Reserve Alan Greenspan, thought financial innovation would be hampered, and financial activity driven to unregulated market overseas, if there were any attempts to impose limits on leverage in the unregulated credit and capital markets. After all, innovation was viewed as the driving force in US prosperity. The global financial system embarked on a race to assume more risk under a mentality of “if I don’t smoke, somebody else will.”
This brave new approach, which all five qualifying broker-dealers - Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley - voluntarily adopted, altered the way the SEC measured their capital. The five big firms led the charge for the net capital rule change to promote financial innovation, spearheaded by Goldman Sachs, then headed by Henry Paulson, who two years later, would leave Goldman to become the Treasury Secretary, who now has to deal with the global mess created by high leverage.
Using computerized models provided by the five big firms, the SEC, under its new Consolidated Supervised Entities (CSE) program, allowed the broker-dealers to increase their debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1. It also removed the method for applying haircuts, relying instead on another math-based computerized model for calculating risk that led to a much smaller discount.
The SEC justified the less stringent capital requirements by arguing it was now able to manage the consolidated entity of the broker-dealer and the holding company, which would ensure better management of risk. “The Commission’s 2004 rules strengthened oversight of the securities markets, because prior to their adoption there was no formal regulatory oversight, no liquidity requirements, and no capital requirements for investment bank holding companies,” a spokesman for the agency rationalized.
In loosening the capital rule, which was supposed to provide a buffer in turbulent times, the SEC also decided to rely on the five big firms’ own computer risk models, essentially outsourcing the job of monitoring risk to the banks it was supposed to supervise. Over subsequent years, all would take advantage of the looser capital rule to increase leverage.
It is now clear that the SEC leverage modification in 2004 is a primary reason for the massive losses that have occurred in 2008.
On Sept. 26, 2008, Chairman Cox announced a decision by the SEC Division of Trading and Markets to end the Consolidated Supervised Entities (CSE) program, created in 2004 as a way for global investment bank conglomerates that lack a supervisor under law to voluntarily submit to regulation. Chairman Cox also described the agency’s plans for enhancing SEC oversight of the broker-dealer subsidiaries of bank holding companies regulated by the Federal Reserve, based on the recent Memorandum of Understanding (MOU) between the SEC and the Fed.
The net capital rule created by the SEC in 1975 required broker-dealers to limit their debt-to-net-capital ratio to 12-to-1, and they must issue early warnings if they began approaching this limit, and were forced to stop trading if they exceeded it, so broker-dealers often kept their debt-to-net capital ratios much lower than 12-1. The rule allowed the SEC to oversee broker-dealers, and required firms to value all of their tradable assets at market prices. The rule applied a haircut, or a discount, to account for the assets’ market risk. Equities, for example, had a haircut of 15%, while a 30-year Treasury bill, because it is less risky, had a 6% haircut. But a 2004 SEC exemption -- given only to five big firms -- allowed them to lever up 30 and even 40 to 1.
The five big firms wanted for their brokerage units an exemption from the 1975 regulation that limited the amount of debt they could take on to $12 for every dollar of equity. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those equity funds could then flow up to the parent company, enabling it to invest in the fast growing but opaque world of mortgage-backed securities, credit derivatives, credit default swaps - a form of insurance for bond holders - and other exotic structured finance instruments
In 2004, the European Union passed a rule allowing the SEC’s European counterpart to manage the risk both of broker dealers and their investment banking holding companies. In response, the SEC instituted a similar, voluntary program for broker-dealers with capital of at least $5 billion, enabling the agency to oversee both the broker-dealers and the holding companies. Ever since the Great Depression, the government has tried to limit the leverage available to the public in the US stock market by maintain margin requirements. But regulators, led by former chairman of the Federal Reserve Alan Greenspan, thought financial innovation would be hampered, and financial activity driven to unregulated market overseas, if there were any attempts to impose limits on leverage in the unregulated credit and capital markets. After all, innovation was viewed as the driving force in US prosperity. The global financial system embarked on a race to assume more risk under a mentality of “if I don’t smoke, somebody else will.”
This brave new approach, which all five qualifying broker-dealers - Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley - voluntarily adopted, altered the way the SEC measured their capital. The five big firms led the charge for the net capital rule change to promote financial innovation, spearheaded by Goldman Sachs, then headed by Henry Paulson, who two years later, would leave Goldman to become the Treasury Secretary, who now has to deal with the global mess created by high leverage.
Using computerized models provided by the five big firms, the SEC, under its new Consolidated Supervised Entities (CSE) program, allowed the broker-dealers to increase their debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1. It also removed the method for applying haircuts, relying instead on another math-based computerized model for calculating risk that led to a much smaller discount.
The SEC justified the less stringent capital requirements by arguing it was now able to manage the consolidated entity of the broker-dealer and the holding company, which would ensure better management of risk. “The Commission’s 2004 rules strengthened oversight of the securities markets, because prior to their adoption there was no formal regulatory oversight, no liquidity requirements, and no capital requirements for investment bank holding companies,” a spokesman for the agency rationalized.
In loosening the capital rule, which was supposed to provide a buffer in turbulent times, the SEC also decided to rely on the five big firms’ own computer risk models, essentially outsourcing the job of monitoring risk to the banks it was supposed to supervise. Over subsequent years, all would take advantage of the looser capital rule to increase leverage.
It is now clear that the SEC leverage modification in 2004 is a primary reason for the massive losses that have occurred in 2008.
On Sept. 26, 2008, Chairman Cox announced a decision by the SEC Division of Trading and Markets to end the Consolidated Supervised Entities (CSE) program, created in 2004 as a way for global investment bank conglomerates that lack a supervisor under law to voluntarily submit to regulation. Chairman Cox also described the agency’s plans for enhancing SEC oversight of the broker-dealer subsidiaries of bank holding companies regulated by the Federal Reserve, based on the recent Memorandum of Understanding (MOU) between the SEC and the Fed.
Chairman Cox made the following statement along with the SEC announcement on ending the CSE:
The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act [on November 12, 1999 to repeal the Glass-Steagall Act of 1933 which had prohibited a bank from offering investment banking and insurance services], it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.
The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act [on November 12, 1999 to repeal the Glass-Steagall Act of 1933 which had prohibited a bank from offering investment banking and insurance services], it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.
Government Backing of Bank-issued debt will make all other forms of debt riskier and more expensive.
The government’s intervention has created a relative advantage for companies to raising funds through guaranteed bank paper versus the asset-backed markets. The ability of banks and other financial groups to raise money via government guarantees means funding through more traditional routes like asset-backed securities will be much more expensive. In the short-term, the government moves is having an effect. There has not been any issuance in credit cards because all the major banks now have another, cheaper option. In addition to offering banks cheaper sources of funding, the explicit government guarantees on many bank securities has led to a sell-off in bonds issued by mortgage financiers like Fannie Mae and Freddie Mac, as well as asset-backed securities. As a result, the cost of borrowing in asset-backed markets has soared, with the premiums over US government bonds at record highs. This makes private sector funding even less attractive.
Wednesday, October 22, 2008
Systemic Insolvency mistaken for liquidity crisis - Oct 22 2008
The diagnosis misjudged the current credit crisis as only a temporary liquidity quandary instead of recognizing it as a systemic insolvency.
The misdiagnosis led to a flawed prognosis that the liquidity crunch could be uncorked by serial injections of more government funds into intractable credit and capital market seizure. This faulty rationale was based on the fantasy that distressed financial institutions holding assets that had become illiquid could be relieved by wholesale monetization of such illiquid asset with government loans, even if such government loans are collateralized by the very same illiquid assets that private investors have continued to shun in the open market. Its not that government officials knows more than market participants about the true value of these illiquid assets; it is only that government officials with access to taxpayer money have decided to ignore market forces to artificially support asset overvaluation, the original root cause of the problem. Instead of being the solution, the government with flawed responses backed by the people’s money has become part of the problem.
Bear Stearns and the failure of the repo market debt
For example, the trigger point behind Bear Stearns’s near failure came from the repo market where banks and securities firms routinely extend and receive short-term loans, typically made overnight and backed by top grade securities. Hours before 7:30 am on March 14, 2008, Bear Stearns was faced with the problem of not being able to roll over its huge repo debt because its high-rated collaterals had fallen in market value. If the firm did not repay the maturing debt on time with new funds from new repo contracts, its creditors could start selling the collateral Bear had pledged to them at fire sale prices to cause substantial loss to Bear Stearns. The implications would go far beyond losses for Bear Stearns. The sale receipts might not repay all investors and cause losses to conservative institutional investors such as pension funds and money market funds. If investors begin to question the safety of loans collateralized by triple-A securities they make in the repo market that are now worth less than their face value, they could start to withhold funds from the credit market when other investment banks and companies need to roll over their maturing short-term debts. Hundred of firms would default and fail from a seizure of the $4.5 trillion repo market, bringing down banks which have issued standby credit to them in a financial chain reaction.
the Logic of Repo Failures
As with other financial markets, repo markets are subject to credit risk, operational risk and liquidity risk. However, what distinguishes the credit risk on repos from that associated with uncollateralized instruments is that repo credit exposures arise from volatility (or market risk) in the value of collateral. For example, a decline in the price of securities serving as collateral can result in an under-collateralization of the repo. Liquidity risk arises from the possibility that a loss of liquidity in collateral markets will force liquidation of collateral at a discount in the event of a counterparty default, or even a fire sale in the event of systemic panic. Leverage that is built up using repos can exponentially increase these risks when the market turns. While leverage facilitates the efficient operation of financial markets, rigorous risk management by market participants using leverage is important to maintain these risks at prudent levels.
The Basic Principle of Structured Finance
Companies involved in structured financing arrangements often consult with credit rating agencies to determine how to structure individual tranches of debt so that each receives a desired credit rating to certify its risk exposure. For example, a firm may wish to borrow a large sum of money by issuing debt securities. However, the amount is so large that the return investors may demand on a single issuance would be prohibitive. Instead, it decides to issue three separate bonds, with three separate credit ratings -- A (medium low risk), BBB (medium risk), and BB (speculative), using Standard & Poor’s rating system. The firm expects that the effective interest rate it pays on the BB-rated bonds will be more than the rate it must pay on the A-rated bonds, but that, overall, the amount it must pay for the total capital it raises will be less than it would pay if the entire amount were raised from a single bond offering. This is the basic principle of structured finance: the squeezing of financial value out of unbundling of debt.
The Fed Supports Money Market Mutual Funds
The US Federal Reserve on October 21 announced it would create a Money Market Investor Funding Facility (MMIFF) to support a private-sector initiative designed to provide liquidity to U.S. money market investors. MMIFF will finance up to $540 billion in purchases of short-term debt from money market mutual funds to shore up a key pillar of the US financial system. It will provide senior secured funding to a series of special purpose vehicles to facilitate an industry-supported private-sector initiative to finance the purchase of eligible assets from eligible investors. Eligible assets will include US dollar-denominated certificates of deposit and commercial paper issued by highly rated financial institutions and having remaining maturities of 90 days or less. Eligible investors will include US money market mutual funds and over time may include other US money market investors.
Money market funds are facing severe redemption pressures since the financial crisis deepened last month, forcing them to raise cash by scaling back their short-term lending to banks and selling their holdings of commercial paper. This retreat has contributed both to a freeze in the interbank market and a steep decline in activity in the commercial paper market, which has made it difficult for banks and companies to raise short-term funds.
Government Strategy Ignores Fundamental Problem of Asset Overvaluation
Although each step by the government in reaction to the credit crisis was a logical, targeted response to new systemic financial upheavals, the result was to prop up select distressed firms deemed too big to fail and support failing markets as they occurred, hoping in vain that it would be the last move needed to resolve the systemic crisis to put the economy on a path of recovery. The Fed and the Treasury appeared to be rushing from emergency to emergency without a strategic plan to deal with the fundamental problem of a debt bubble collapse.
The disjointed interventions appeared designed to keep a collapsing debt bubble from collapsing, a hopeless task that even Alan Greenspan, the bubble wizard par excellence, was not naive enough to try. Greenspan merely replaced a burst bubble with a new bigger bubble, never tried to keep stop a collapsing bubble in mid course. Greenspan’s approach was that of a post disaster cleanup crew, not rushing into a collapsing structure as the current bailout team appears to be trying to do. Throwing good money after bad merely makes good money into bad. Spending good money after the collapse would infinitely buy more in the cleanup task
Global Bank Bailout by Central Banks
Prompted by the US, governments across Europe took action to bail out their respective banks and protect their separate banking systems after the G7 meeting in Washington during the weekend of October 11.
France extended state guarantee to $435 billion of senior bank debt to help jumpstart French credit markets. It created a state company with up to $54 billion in capital to recapitalize distressed French banks. The UK guaranteed $434 billion of bank debts and injected $64 billion into Royal Bank of Scotland Group, HBOS, a banking/insurance group in the UK, and Lloyds TSB Group, as part of its already announced £400 billion bail-out plan. Germany guaranteed up to $544 billion inter-bank debts, setting aside $27 billion for potential losses and injected up to $109 billion equity in German banks. Italy announced it will recapitalize Italian banks and guarantee bonds on a case-by-case basis. Spain will guarantee $136 billion in Spanish bank debts, set up preventive facility to inject new capital into distressed Spanish banks until 2009 and established up to $68 billion to buy Spanish bank assets. The Netherlands is injecting €10 billion ($13.4 billion) into ING Group, the banking and insurance gaint who just weeks earlier was the white knight to bail out troubled Fortis NV. Austria, Portugal and Norway joined the effort, committing a total of €501 billion in guarantees and capital for banks in their respective jurisdiction.
The misdiagnosis led to a flawed prognosis that the liquidity crunch could be uncorked by serial injections of more government funds into intractable credit and capital market seizure. This faulty rationale was based on the fantasy that distressed financial institutions holding assets that had become illiquid could be relieved by wholesale monetization of such illiquid asset with government loans, even if such government loans are collateralized by the very same illiquid assets that private investors have continued to shun in the open market. Its not that government officials knows more than market participants about the true value of these illiquid assets; it is only that government officials with access to taxpayer money have decided to ignore market forces to artificially support asset overvaluation, the original root cause of the problem. Instead of being the solution, the government with flawed responses backed by the people’s money has become part of the problem.
Bear Stearns and the failure of the repo market debt
For example, the trigger point behind Bear Stearns’s near failure came from the repo market where banks and securities firms routinely extend and receive short-term loans, typically made overnight and backed by top grade securities. Hours before 7:30 am on March 14, 2008, Bear Stearns was faced with the problem of not being able to roll over its huge repo debt because its high-rated collaterals had fallen in market value. If the firm did not repay the maturing debt on time with new funds from new repo contracts, its creditors could start selling the collateral Bear had pledged to them at fire sale prices to cause substantial loss to Bear Stearns. The implications would go far beyond losses for Bear Stearns. The sale receipts might not repay all investors and cause losses to conservative institutional investors such as pension funds and money market funds. If investors begin to question the safety of loans collateralized by triple-A securities they make in the repo market that are now worth less than their face value, they could start to withhold funds from the credit market when other investment banks and companies need to roll over their maturing short-term debts. Hundred of firms would default and fail from a seizure of the $4.5 trillion repo market, bringing down banks which have issued standby credit to them in a financial chain reaction.
the Logic of Repo Failures
As with other financial markets, repo markets are subject to credit risk, operational risk and liquidity risk. However, what distinguishes the credit risk on repos from that associated with uncollateralized instruments is that repo credit exposures arise from volatility (or market risk) in the value of collateral. For example, a decline in the price of securities serving as collateral can result in an under-collateralization of the repo. Liquidity risk arises from the possibility that a loss of liquidity in collateral markets will force liquidation of collateral at a discount in the event of a counterparty default, or even a fire sale in the event of systemic panic. Leverage that is built up using repos can exponentially increase these risks when the market turns. While leverage facilitates the efficient operation of financial markets, rigorous risk management by market participants using leverage is important to maintain these risks at prudent levels.
The Basic Principle of Structured Finance
Companies involved in structured financing arrangements often consult with credit rating agencies to determine how to structure individual tranches of debt so that each receives a desired credit rating to certify its risk exposure. For example, a firm may wish to borrow a large sum of money by issuing debt securities. However, the amount is so large that the return investors may demand on a single issuance would be prohibitive. Instead, it decides to issue three separate bonds, with three separate credit ratings -- A (medium low risk), BBB (medium risk), and BB (speculative), using Standard & Poor’s rating system. The firm expects that the effective interest rate it pays on the BB-rated bonds will be more than the rate it must pay on the A-rated bonds, but that, overall, the amount it must pay for the total capital it raises will be less than it would pay if the entire amount were raised from a single bond offering. This is the basic principle of structured finance: the squeezing of financial value out of unbundling of debt.
The Fed Supports Money Market Mutual Funds
The US Federal Reserve on October 21 announced it would create a Money Market Investor Funding Facility (MMIFF) to support a private-sector initiative designed to provide liquidity to U.S. money market investors. MMIFF will finance up to $540 billion in purchases of short-term debt from money market mutual funds to shore up a key pillar of the US financial system. It will provide senior secured funding to a series of special purpose vehicles to facilitate an industry-supported private-sector initiative to finance the purchase of eligible assets from eligible investors. Eligible assets will include US dollar-denominated certificates of deposit and commercial paper issued by highly rated financial institutions and having remaining maturities of 90 days or less. Eligible investors will include US money market mutual funds and over time may include other US money market investors.
Money market funds are facing severe redemption pressures since the financial crisis deepened last month, forcing them to raise cash by scaling back their short-term lending to banks and selling their holdings of commercial paper. This retreat has contributed both to a freeze in the interbank market and a steep decline in activity in the commercial paper market, which has made it difficult for banks and companies to raise short-term funds.
Government Strategy Ignores Fundamental Problem of Asset Overvaluation
Although each step by the government in reaction to the credit crisis was a logical, targeted response to new systemic financial upheavals, the result was to prop up select distressed firms deemed too big to fail and support failing markets as they occurred, hoping in vain that it would be the last move needed to resolve the systemic crisis to put the economy on a path of recovery. The Fed and the Treasury appeared to be rushing from emergency to emergency without a strategic plan to deal with the fundamental problem of a debt bubble collapse.
The disjointed interventions appeared designed to keep a collapsing debt bubble from collapsing, a hopeless task that even Alan Greenspan, the bubble wizard par excellence, was not naive enough to try. Greenspan merely replaced a burst bubble with a new bigger bubble, never tried to keep stop a collapsing bubble in mid course. Greenspan’s approach was that of a post disaster cleanup crew, not rushing into a collapsing structure as the current bailout team appears to be trying to do. Throwing good money after bad merely makes good money into bad. Spending good money after the collapse would infinitely buy more in the cleanup task
Global Bank Bailout by Central Banks
Prompted by the US, governments across Europe took action to bail out their respective banks and protect their separate banking systems after the G7 meeting in Washington during the weekend of October 11.
France extended state guarantee to $435 billion of senior bank debt to help jumpstart French credit markets. It created a state company with up to $54 billion in capital to recapitalize distressed French banks. The UK guaranteed $434 billion of bank debts and injected $64 billion into Royal Bank of Scotland Group, HBOS, a banking/insurance group in the UK, and Lloyds TSB Group, as part of its already announced £400 billion bail-out plan. Germany guaranteed up to $544 billion inter-bank debts, setting aside $27 billion for potential losses and injected up to $109 billion equity in German banks. Italy announced it will recapitalize Italian banks and guarantee bonds on a case-by-case basis. Spain will guarantee $136 billion in Spanish bank debts, set up preventive facility to inject new capital into distressed Spanish banks until 2009 and established up to $68 billion to buy Spanish bank assets. The Netherlands is injecting €10 billion ($13.4 billion) into ING Group, the banking and insurance gaint who just weeks earlier was the white knight to bail out troubled Fortis NV. Austria, Portugal and Norway joined the effort, committing a total of €501 billion in guarantees and capital for banks in their respective jurisdiction.
Friday, October 17, 2008
commercial paper - Henry Liu - Nov 2007
Commercial paper has become an important debt market because of the advantages of commercial paper for both investors and issuers. Commercial paper outstanding grew at an annual rate of 14% from 1970 to 1991, totaling $528 billion at the end of 1991. Until the recent market seizure, the commercial paper market was a $3 trillion market with half of the market consisting of bank-financed “conduits” of asset backed commercial paper (ABCP). The ABCP market shrank 13% in August 2007 as US companies struggled unsuccessfully to raise short-term funds to roll over maturing outstanding debts
Characteristics of Commercial Paper
Securities offered to the public must be registered with the Securities and Exchange Commission according to the Securities Act of 1933. Registration requires extensive public disclosure, including issuing a prospectus on the offering. It is a time-consuming and expensive process. Most commercial paper is issued under Section 3(a)(3) of the 1933 Act which exempts from registration requirements short-term securities with certain characteristics. The exemption requirements have been a factor shaping the characteristics of the commercial paper market. The key requirement for exemption is that the maturity of commercial paper must be less than 270 days. In practice, most commercial paper has a maturity of between 5 and 45 days, with 30-35 days being the average maturity. Many issuers continuously roll over their commercial paper, financing a more-or-less constant amount of their assets using commercial paper. The nine-month maturity limit is not violated by the continuous rollover of notes, as long as the rollover is not automatic but is at the discretion of the issuer and the dealer. Many issuers will adjust the maturity of commercial paper to suit the requirements of an investor.
Notes must be of a type not ordinarily purchased by the general public. In practice, the denomination of commercial paper is large: minimum denominations are usually $100,000, although face amounts as low as $10,000 are available from some issuers. Typical face amounts are in multiples of $1 million, because most investors are institutions. Issuers will usually sell an investor the specific amount of commercial paper needed.
That proceeds from commercial paper issues can be used to finance “current transactions”, which include the funding of operating expenses and the funding of current assets such as receivables and inventories. Proceeds cannot be used to finance fixed assets, such as plant and equipment, on a permanent basis. The SEC has generally interpreted the current transaction requirement broadly, approving a variety of short-term uses for commercial paper proceeds as proceeds are not traced directly from issue to use. Firms are required to show only that they have a sufficient "current transaction" capacity to justify the size of the commercial paper program. For example, a particular level of receivables or inventory. Firms are allowed to finance construction as long as the commercial paper financing is temporary and to be paid off shortly after completion of construction with long-term funding through a bond issue, bank loan, or internally generated cash flow.
Liu excerpted from http://www.eagletraders.com/neg_financial_instruments/commercial_paper_o.htm
Characteristics of Commercial Paper
Securities offered to the public must be registered with the Securities and Exchange Commission according to the Securities Act of 1933. Registration requires extensive public disclosure, including issuing a prospectus on the offering. It is a time-consuming and expensive process. Most commercial paper is issued under Section 3(a)(3) of the 1933 Act which exempts from registration requirements short-term securities with certain characteristics. The exemption requirements have been a factor shaping the characteristics of the commercial paper market. The key requirement for exemption is that the maturity of commercial paper must be less than 270 days. In practice, most commercial paper has a maturity of between 5 and 45 days, with 30-35 days being the average maturity. Many issuers continuously roll over their commercial paper, financing a more-or-less constant amount of their assets using commercial paper. The nine-month maturity limit is not violated by the continuous rollover of notes, as long as the rollover is not automatic but is at the discretion of the issuer and the dealer. Many issuers will adjust the maturity of commercial paper to suit the requirements of an investor.
Notes must be of a type not ordinarily purchased by the general public. In practice, the denomination of commercial paper is large: minimum denominations are usually $100,000, although face amounts as low as $10,000 are available from some issuers. Typical face amounts are in multiples of $1 million, because most investors are institutions. Issuers will usually sell an investor the specific amount of commercial paper needed.
That proceeds from commercial paper issues can be used to finance “current transactions”, which include the funding of operating expenses and the funding of current assets such as receivables and inventories. Proceeds cannot be used to finance fixed assets, such as plant and equipment, on a permanent basis. The SEC has generally interpreted the current transaction requirement broadly, approving a variety of short-term uses for commercial paper proceeds as proceeds are not traced directly from issue to use. Firms are required to show only that they have a sufficient "current transaction" capacity to justify the size of the commercial paper program. For example, a particular level of receivables or inventory. Firms are allowed to finance construction as long as the commercial paper financing is temporary and to be paid off shortly after completion of construction with long-term funding through a bond issue, bank loan, or internally generated cash flow.
Liu excerpted from http://www.eagletraders.com/neg_financial_instruments/commercial_paper_o.htm
Saturday, September 20, 2008
AIG, Lehman, RTC 2? - Too big to fail - Sep 19 2008
The way the Fed has been trying to stabilize the financial market in this horrendous credit crisis since it burst open in August 2007 is looking like punching new gaping holes in the throat of the patient to deliver more air to his lungs. One of these days, it may accidentally puncture a jugular vein to end the game. The lender of last resort has become a predator of last resort, nationalizing all dying enterprises. But it seems to be racing headlong onto the road of nationalization not so much as to help the common people as to keep dying financial dinosaurs alive.
The Fed continues to pretend that firms likes AIG are merely going through a liquidity crunch. The fact is that undercapitalization is by definition a solvency problem. The problem is not that good assets are temporarily hit with prices below their real worth and that new capital is needed to maintain debt to equity ratio. The problem is that all these debts were not worth their face value to begin with. The high inflated market values of these assets were held up by circular trading of debt by assuming that they could always be sold at still higher prices way beyond their true worth. Now that the market is finally adjusting the price bubble downward and a lot of firm who were incredibly profitable on the way up are falling like leave in autumn in a bear market. The Fed is merely trying to inject money to keep prices not supported by fundamentals from falling. It is a prescription for hyperinflation. The only way to keep price of worthless assets high is to lower the value of money. And that appears to be the Fed unspoken strategy.
AIG is faced with $441 billion of exposure to credit-default swaps and other derivatives. Losses on these contracts have driven AIG into a vicious downwards spiral in which it needs ever more cash to remain a top-rated counterparty. JPMorgan Chase and Goldman Sachs had been charged by the government with finding $75 billion from private sources to rescue failing firm. They both failed. The shares of Morgan Stanley and Goldman Sachs themselves were down sharply one day after the Fed issue an $85 billion bridge loan to keep AIG from defaulting.Saturday, September 06, 2008
Milton Friedman - Business vs Economy Sep 5 2008
The market is merely the transactional record of the economy. Students of the market economy tend to confuse business, which is transacted in the market, as the whole economy itself. That is the problem with Business School economists who really should be called “busi-nomists” rather than eco-nomists because by definition and by design they are not concerned with eco, a Greek word “oikos” meaning house. The word describes the complex symbiotic relationships of all living organisms in relation to their environment in the eco-system. Business is ony a subsystem of the socio-economic ecosystem. The goal of busi-nomists is to keep the business cycle from recurring crashes even if it means destroying the economy in the process. To achieve this goal, central banking was invented.
This is not to denigrate business experts. All experts, however narrow, perform useful functions and brilliant experts deserve admiration. It is just that they should refrain from fantasizing that they are generalists dealing with the economy. Business exists to make profit for the businessman and there is nothing wrong with that as long as ethical rules are observed. Unlike business, the economy exists to enhance progress in civilization. The former is artificial, the latter is actual. The key problem of the recent decades of Friedman monetarism has not been that money matters but that it matters too much.
Tuesday, July 29, 2008
Labor-theory of Value turned upside down
World trade is now a game in which the US produces fiat dollars of uncertain exchange value and zero intrinsic value, and the rest of the world produces goods and services that fiat dollars can buy at “market prices” quoted in dollars. Such market prices are no longer based on mark-ups over production costs set by socio-economic conditions in the producing countries. They are kept artificially low to compensate for the effect of overcapacity in the global economy created by a combination of overinvestment and weak demand due to low wages in every economy. Such low market prices in turn push further down already low wages to further cut cost in an unending race to the bottom. The higher the production volume above market demand, the lower the unit market price of a product must go in order to increase sales volume to keep revenue from falling. Lower market prices require lower production costs which in turn push wages lower. Lower wages in turn further reduces demand. To prevent loss of revenue from falling prices, producers must produce at still higher volume, thus lowering still market prices and wages in a downward spiral. Export economies are forced to compete for market share in the global market by lowering both domestic wages and the exchange rate of their currencies. Lower exchange rates push up the market price of commodities which must be compensated by even lower wages. The adverse effects of dollar hegemony on wages apply not only to the emerging export economies, but also to the importing US economy. Workers all over the world are oppressed victims of dollar hegemony which turns the labor theory of value up-side-down..
In a global market operating under dollar hegemony, the world’s interlinked economies no longer trade to capture Ricardian comparative advantage. The theory of comparative advantage as espoused by British economist David Ricardo (1772-1823) asserts that trade can benefit all participating nations, even those who command no absolute advantage, because such nations can still benefit from specializing in producing products with the lowest opportunity cost, which is measured by how much production of another good needs to be reduced to increase production by one additional unit of that good. This theory reflected British national opinion at the 19th century when free trade benefited Britain more than its trade partners. However, in today’s globalized trade when factors of production such as capital, credit, technology, management, information, branding, distribution and sales are mobile across national borders and can generate profit much greater than manufacturing, the theory of comparative advantage has a hard time holding up against measurable data.
Holy Dollar Empire
Echoing the Holy Roman Empire, the global economy has been operating as a global Holy Dollar Empire with the Federal Reserve as the Holy Dollar Emperor. Similar to the Holy Roman Empire which disintegrated from the rise of Lutheran nationalism, this Holy Dollar Empire will eventually disintegrate from progressive centrifugal forces of a new populist economic nationalism. This new populist economic nationalism is not to be confused with regressive trade protectionism. The formation of the new Group of Five (G5 - China, Brazil, India, Mexico and South Africa) in the 2008 Group of Eight Summit in Tokyo (G8 – US, UK, Germany, France, Italy, Japan, Russia and the European Union) is a sign of this new trend of progressive new economic nationalism. The 2008 US presidential election may herald in a new populism in US history to reform the structure of US debt capitalism. In his speech to the G5 leaders, President Hu Jintao said: “It is necessary to take into full account the issue of food security in tackling the challenges in energy, climate change and other fields.” Apart from calling for the setting up of an UN-led international co-operation mechanism and a global food-security safeguard system, Hu said all countries should strengthen co-operation in grain reserves, a process of proven success in China but not recommended by the UN Food and Agriculture Organization which views such scheme as a distortion of trade. Liberation from this Holy Dollar Empire of dollar hegemony can only come from sovereign nations withdrawing from the global central banking regime to return to a national banking regime within a world order of sovereign nation states to put monetary policy back in its proper role of supporting national development goals, rather than sacrificing national development to support global dollar hegemony through wage-suppressing export-led growth. In a world order of sovereign nation states, the supranational nature of central banking will render it inoperative, as it can be and has been used as an all-controlling device for the world’s rich nation to neutralize the sovereign rights of financially weak nations. In a democratic world order, central banking is also inoperative within national borders, as it can be used by a nation’s rich as a device to deny the working poor of their economic rights. Central banking, in its support of dollar hegemony, operates internationally in opposition to the economic interests of sovereign nation states and domestically in opposition to the economic rights of the working poor by discrediting enlightened economic nationalism as undesirable protectionism.
In a global market operating under dollar hegemony, the world’s interlinked economies no longer trade to capture Ricardian comparative advantage. The theory of comparative advantage as espoused by British economist David Ricardo (1772-1823) asserts that trade can benefit all participating nations, even those who command no absolute advantage, because such nations can still benefit from specializing in producing products with the lowest opportunity cost, which is measured by how much production of another good needs to be reduced to increase production by one additional unit of that good. This theory reflected British national opinion at the 19th century when free trade benefited Britain more than its trade partners. However, in today’s globalized trade when factors of production such as capital, credit, technology, management, information, branding, distribution and sales are mobile across national borders and can generate profit much greater than manufacturing, the theory of comparative advantage has a hard time holding up against measurable data.
Holy Dollar Empire
Echoing the Holy Roman Empire, the global economy has been operating as a global Holy Dollar Empire with the Federal Reserve as the Holy Dollar Emperor. Similar to the Holy Roman Empire which disintegrated from the rise of Lutheran nationalism, this Holy Dollar Empire will eventually disintegrate from progressive centrifugal forces of a new populist economic nationalism. This new populist economic nationalism is not to be confused with regressive trade protectionism. The formation of the new Group of Five (G5 - China, Brazil, India, Mexico and South Africa) in the 2008 Group of Eight Summit in Tokyo (G8 – US, UK, Germany, France, Italy, Japan, Russia and the European Union) is a sign of this new trend of progressive new economic nationalism. The 2008 US presidential election may herald in a new populism in US history to reform the structure of US debt capitalism. In his speech to the G5 leaders, President Hu Jintao said: “It is necessary to take into full account the issue of food security in tackling the challenges in energy, climate change and other fields.” Apart from calling for the setting up of an UN-led international co-operation mechanism and a global food-security safeguard system, Hu said all countries should strengthen co-operation in grain reserves, a process of proven success in China but not recommended by the UN Food and Agriculture Organization which views such scheme as a distortion of trade. Liberation from this Holy Dollar Empire of dollar hegemony can only come from sovereign nations withdrawing from the global central banking regime to return to a national banking regime within a world order of sovereign nation states to put monetary policy back in its proper role of supporting national development goals, rather than sacrificing national development to support global dollar hegemony through wage-suppressing export-led growth. In a world order of sovereign nation states, the supranational nature of central banking will render it inoperative, as it can be and has been used as an all-controlling device for the world’s rich nation to neutralize the sovereign rights of financially weak nations. In a democratic world order, central banking is also inoperative within national borders, as it can be used by a nation’s rich as a device to deny the working poor of their economic rights. Central banking, in its support of dollar hegemony, operates internationally in opposition to the economic interests of sovereign nation states and domestically in opposition to the economic rights of the working poor by discrediting enlightened economic nationalism as undesirable protectionism.
Monday, July 21, 2008
Debt capitalism self-destructs
The once-dynamic US economy has turned itself into a system in which it is difficult to find any institution, company or individual not over their head in speculative debt. Undercapitalized capitalism, also known as debt capitalism, has been the engine of growth for the US debt bubble in the last two decades. This debt capitalism cancer is caused by a failure of central banking
The backing of the GSEs enabled securitization of "ninja" mortgages (no income, no job or assets), loans that no one would buy if they were not guaranteed by the government. Thus the fault did not lie with mortgage originators, for they would not be able to issue shaky mortgages unless there was a market for them. GSEs' abuse of their alleged government guarantee had rendered market discipline inoperative, allowing the system to go on a wide joyride that was bound to crash of a cliff. Because of their complexity and broad distribution, when securitized debts default, restructuring is almost impossible. There is no effective fire break once the fire begins and quickly engulfs the whole market
In 1968, then president Lyndon Johnson, as part of his Great Society program, turned Fannie into a shareholder-owned company as part of a national housing policy to make finance capitalism finance the nationalization of housing. It was the beginning of corporate market socialism in the name of populist economic democracy. The public could only benefit if corporate and financial institutional interests could profit first. And the public must pay if market capitalism fails systemically, absolving the losses of wayward corporations and financial institutions.
In 1970, the savings and loan industry, envying the huge profit made by commercial and investment banks from Fannie Mae, called for and received congressional approval for a GSE of their own and Congress created Freddie Mac. Like the Urban Renewal program of the 1950s, the GSEs served a coalition of interest that included liberals who wanted to help low-income households, real state developers that wanted guaranteed demand, home builders that wanted a guaranteed market, local politicians who wanted tax revenue from redevelopment, banks that wanted lucrative risk-free loan proceeds and congressmen who wanted campaign contributions from mortgage lenders.
The GSEs have been financially successful because they combine private sector appetite for profit with access to government-backed credit at below market rates. It was a way to nationalize housing through the free market capitalism. The problem was that financial manipulation cannot replace the need for adequate income growth. The mismatch of income with asset price is the definition of a financial bubble. People were buying homes with cheap credit at prices that their income could not afford. The more home prices rose due to cheap credit, the more homeowners fell into the debt trap. Yet in all the current talk about finding ways to deal with the crisis, not one single voice is heard from official circles about the need to increase worker income. Instead, false hopes on one-time stimulant tax rebates are hailed as the magic bullet.
The backing of the GSEs enabled securitization of "ninja" mortgages (no income, no job or assets), loans that no one would buy if they were not guaranteed by the government. Thus the fault did not lie with mortgage originators, for they would not be able to issue shaky mortgages unless there was a market for them. GSEs' abuse of their alleged government guarantee had rendered market discipline inoperative, allowing the system to go on a wide joyride that was bound to crash of a cliff. Because of their complexity and broad distribution, when securitized debts default, restructuring is almost impossible. There is no effective fire break once the fire begins and quickly engulfs the whole market
In 1968, then president Lyndon Johnson, as part of his Great Society program, turned Fannie into a shareholder-owned company as part of a national housing policy to make finance capitalism finance the nationalization of housing. It was the beginning of corporate market socialism in the name of populist economic democracy. The public could only benefit if corporate and financial institutional interests could profit first. And the public must pay if market capitalism fails systemically, absolving the losses of wayward corporations and financial institutions.
In 1970, the savings and loan industry, envying the huge profit made by commercial and investment banks from Fannie Mae, called for and received congressional approval for a GSE of their own and Congress created Freddie Mac. Like the Urban Renewal program of the 1950s, the GSEs served a coalition of interest that included liberals who wanted to help low-income households, real state developers that wanted guaranteed demand, home builders that wanted a guaranteed market, local politicians who wanted tax revenue from redevelopment, banks that wanted lucrative risk-free loan proceeds and congressmen who wanted campaign contributions from mortgage lenders.
The GSEs have been financially successful because they combine private sector appetite for profit with access to government-backed credit at below market rates. It was a way to nationalize housing through the free market capitalism. The problem was that financial manipulation cannot replace the need for adequate income growth. The mismatch of income with asset price is the definition of a financial bubble. People were buying homes with cheap credit at prices that their income could not afford. The more home prices rose due to cheap credit, the more homeowners fell into the debt trap. Yet in all the current talk about finding ways to deal with the crisis, not one single voice is heard from official circles about the need to increase worker income. Instead, false hopes on one-time stimulant tax rebates are hailed as the magic bullet.
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