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Posts Tagged ‘Finance’

Eugene Fama, Lars Peter Hansen, and Robert Shiller won the Nobel Prize in Economics this morning for their work studying asset prices. In one sense, they are a motley trio: Fama is famous for emphasizing efficient markets, Shiller for emphasizing investor psychology and inefficient markets, and Hansen for high-tech econometric techniques that are used well beyond finance. The unifying theme is their shared interest in understanding the predictability, if any, of asset prices.

The Royal Swedish Academy of Sciences posted an accessible summary of their work. Here’s the intro:

There is no way to predict whether the price of stocks and bonds will go up or down over the next few days or weeks. But it is quite possible to foresee the broad course of the prices of these assets over longer time periods, such as, the next three to five years. These findings, which may seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller.

Fama, Hansen, and Shiller have developed new methods for studying asset prices and used them in their investigations of detailed data on the prices of stocks, bonds and other assets. Their methods have become standard tools in academic research, and their insights provide guidance for the development of theory as well as for professional investment practice. Although we do not yet fully understand how asset prices are determined, the research of the Laureates has revealed a number of important regularities that are helping us to arrive at better explanations.

The predictability of asset prices is closely related to how markets function, and that’s why researchers are so interested in this question. If markets work well, prices should have very little predictability. This statement may seem paradoxical, but consider the following: suppose investors could predict that a certain stock would increase a lot in value over the next year. Then they would buy the stock immediately, driving up the price until it is so high that the stock is no longer attractive to buy. What remains is an unpredictable price pattern, with random movements that reflect the arrival of news. In technical jargon, prices then follow a “random walk.”

There are, however, reasons why prices may follow somewhat predictable patterns even in a well-functioning market. A key factor is risk. Risky assets are less attractive to investors, so on average, a risky asset will need to deliver a higher return. A higher return for the risky asset means that its price can be predicted to rise faster than for safe assets. To detect market malfunctioning, then, one would need to have an idea of what a reasonable compensation for risk ought to be. The issue of predictability and the issue of normal returns that compensate for risk are intertwined. The three Laureates have shown how to disentangle these issues and analyze them empirically.

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Since the day of Alexander Hamilton, the United States has never defaulted on the federal debt.

That’s what we budget-watchers always say. It’s a great talking point. One that helps bolster the argument that default should not be an option in Washington’s latest debt limit showdown.

There’s just one teensy problem: it isn’t exactly true. The United States defaulted on some Treasury bills in 1979 (ht: Jason Zweig). And it paid a steep price for stiffing bondholders.

Terry Zivney and Richard Marcus describe the default in The Financial Review (sorry, I can’t find an ungated version):

Investors in T-bills maturing April 26, 1979 were told that the U.S. Treasury could not make its payments on maturing securities to individual investors. The Treasury was also late in redeeming T-bills which become due on May 3 and May 10, 1979. The Treasury blamed this delay on an unprecedented volume of participation by small investors, on failure of Congress to act in a timely fashion on the debt ceiling legislation in April, and on an unanticipated failure of word processing equipment used to prepare check schedules.

The United States thus defaulted because Treasury’s back office was on the fritz in the wake of a debt limit showdown.

This default was temporary. Treasury did pay these T-bills after a short delay. But it balked at paying additional interest to cover the period of delay. According to Zivney and Marcus, it required both legal arm twisting and new legislation before Treasury made all investors whole for that additional interest.

The United States thus did default once. It was small. It was unintentional. But it was indeed a default.

And the nation still stands. But that hardly means we should run the experiment again and at larger scale. Zivney and Marcus examined what happened to T-bill interest rates as a result of this small, temporary default. They find a surprisingly large effect. As best they can tell, T-bill interest rates increased about 60 basis points after the first default and remained elevated for at least several months thereafter. A simple way to see that is to look at daily changes in T-bill yields:

1979 Treasury Default

T-bill rates spiked upwards four times in the months around the default. In November 1978, Henry “Dr. Doom” Kaufman predicted that interest rates would rise. They did. Turn-of-the-year cash management disrupted rates as 1978 became 1979. And rates spiked and fell in October 1979 when Paul Volcker announced that the Fed would target monetary aggregates rather than interest rates (the “Saturday night special”).

The fourth big move was the day of the first default, when T-bill rates rose almost 0.6 percentage points (i.e., 60 basis points).There’s no indication this increase reversed in the days that followed (the vertical line on the chart is just a marker for the day of default). Indeed, using more sophisticated means, including comparing T-bill rates to interest on commercial paper, the authors conclude that default led to a persistent increase in T-bill rates and, therefore, higher borrowing costs for the federal government.

The financial world has changed dramatically in the intervening decades. T-bill rates hover near zero compared to the 9-10 percent range of the late 1970s; that means a temporary delay in payments would be less costly for creditors. Treasury’s IT systems are, one hopes, more reliable that 1970s vintage word processors. And one should take care not to make too much of a single data point.

But it’s the only data point we have on a U.S. default. Not surprisingly it shows that even small, temporary default is a bad idea. Our leaders shouldn’t come close to risking it.

P.S. Some observers believe the United States also defaulted in 1933 when it abrogated the gold clause. The United States made its payments on time in dollars, but eliminated the option to take payment in gold. For a quick overview of this and related issues, see this blog post by Catherine Rampell and the associated comments.

P.P.S. This post originally appeared in May 2011. This version has been slightly edited.

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Want to buy a bitcoin?

If you click over to Mt. Gox, the most famous bitcoin exchange, one unit of the crypto-currency will set you back $145. But at Bitstamp you would pay only $129. (At time of writing; prices can change quickly.)

Mt. Gox traders are thus paying a 12% premium for their bitcoins.

That spread seems to violate a fundamental economic law. When transaction costs are low, identical items should trade at nearly identical prices. Otherwise, arbitrageurs would step in to buy cheap and sell dear until the price gap narrows.

But that isn’t happening.

The “law of one price” used to hold. Last fall and winter bitcoin prices at the two big exchanges typically differed by less than 2 percent, a reasonable range given exchange fees and the cost of money transfers (click here if you don’t see the chart or want it bigger):

Bitcoin Spread

In April, however, the bitcoin market went haywire. After spiking to $266 on Mt. Gox, bitcoin prices cratered, falling as low as $54 just two days later. That volatility created large, but temporary spreads between prices on different exchanges (and made it difficult to measure spreads accurately).

When conditions calmed, spreads returned to normal. And then Mt. Gox’s troubles began.

On May 14 the U.S. government accused the exchange of operating an illegal money service business. The government seized $5 million that Mt. Gox held at Dwolla (an online payment processor) and Wells Fargo.

Fearing for their money, Mt. Gox customers converted their at-risk dollars into easy-to-withdraw bitcoins, and the Mt. Gox-Bitstamp spread spiked to 5%.

Spreads briefly normalized until Mt. Gox announced that it was suspending U.S. dollar withdrawals. Mt. Gox had become a Roach Motel (or, if you prefer, a Hotel California) for U.S. dollars. Traders could check their dollars in, but they couldn’t check them out.

Customers responded as you would expect. The spread spiked to 6%, as Mt. Gox traders again converted dollars into bitcoins. The spread briefly narrowed after Mt. Gox’s July 4 announcement of resumed dollar withdrawals. But spreads then spiked to record levels once Mt. Gox customers started reporting that withdrawals remained slow or nonexistent.

Mt. Gox prices are higher than on Bitstamp today because customers apparently can’t get their dollars out of Mt. Gox. So they pay extra for bitcoins. For those customers, a Mt. Gox bitcoin is different from one anywhere else. So the Mt. Gox price isn’t a clean measure of a bitcoin’s value. Instead, it measures the value of a bitcoin plus the desperation of Mt. Gox’s customers.

But that still leaves a puzzle. It makes sense that customers will pay a premium to get their money out. But who is willing to take the other side of the trade, selling bitcoins in return for “Mt. Gox dollars”?

As best as I can tell, those traders have stayed silent on the bitcoin chat boards. Perhaps they are newcomers who think they’ve found an arbitrage opportunity and don’t realize their dollars will be hard to withdraw. Or perhaps they believe that Mt. Gox will get its act together. (A more sinister take, raised on the boards, is that some preferred traders do have the ability to withdraw.) Whatever the case, they stand to make a tidy profit if they can get their dollars out, and sorely disappointed if they can’t.

Sources: For a quick explanation of bitcoin, try this introduction. For price data from numerous exchanges, visit bitcoin charts. My chart uses a 7-day moving average of spreads to smooth the volatility. The measured spread has at times been much higher, e.g., 40%+ on April 10, but that passed quickly.

Disclosure: I own 0.1 bitcoin.

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Is the Federal Reserve part of the government? You might think so, but you wouldn’t know it from the way we talk about America’s debt. When it comes to the debt held by the public, for example, the Fed is just a member of the public.

That accounting reflects the Fed’s unusual independence from the rest of government. The Fed remits its profits to the U.S. Treasury each year, but is otherwise ignored when thinking about fiscal policy.

In the era of quantitative easing, that accounting warrants a second look. The Fed now owns $2 trillion in Treasury bonds and $1.5 trillion in other financial assets. Those assets, and the way the Fed finances them, could have significant budget implications.

To understand them, we’ve calculated what the federal government’s debt and financial asset positions look like when you combine the regular government with the Federal Reserve, taking care to net out the debt owned by the Fed and Treasury cash deposited at the Fed:

Treasury-e1373912099336

 

This consolidated view offers five insights about America’s debt situation:

1.     Less long-term debt. The Fed has bought $2 trillion of Treasury debt with maturities of a year or more. As a result, $2 trillion of medium- and long-term public debt is not, in fact, held by the real public. Interest payments continue, but they cycle from the Treasury to the Fed and then back again when the Fed remits its profits to Treasury. (This debt would become fully public again if the Fed ever decides to sell or allows the debt to mature without replacing it.)

2.     More short-term debt. The Fed needs resources to buy longer-term Treasuries, mortgage-backed securities, and other financial assets. In the early days of the crisis response, it did so by selling the short-term Treasuries it owned. But those eventually ran out. So the Fed began financing its purchases by creating new bank reserves. Those reserves now account for $2 trillion of the Fed’s $2.3 trillion in short-term borrowing, on which it currently pays 0.25 percent interest.

3.     Slightly more overall debt. The official public debt currently stands at $11.9 trillion. When we add in the Fed, that figure rises to $12.1 trillion. Bank reserves and other short-term Fed borrowings more than offset the Fed’s portfolio of Treasury bonds.

4.     Lots more financial assets. Treasury’s financial assets now total $1.1 trillion. That figure more than doubles to $2.5 trillion when we add in the Fed’s mortgage-backed securities and other financial assets.

5.     Less debt net of financial assets. The Fed adds more in financial assets than in government debt, so the debt net of financial assets falls from $10.8 trillion to $9.6 trillion. That $1.2 trillion difference reflects the power of the printing press. As America’s monetary authority, the Fed has issued $1.2 trillion in circulating currency to help finance its portfolio. That currency is technically a government liability, but it bears no interest and imposes no fiscal burden.

The Fed thus strengthens the government’s net financial position, but increases the fiscal risk of future increases in interest rates. When the Fed buys Treasuries, for example, it replaces long-term debts with very short-term ones, bank deposits. That’s been a profitable trade in recent years, with short-term interest rates near zero. But it means federal coffers will be more exposed to future hikes in short-term interest rates, if and when they occur.

This post was coauthored by Hillel Kipnis, who is interning at the Urban Institute this summer. Earlier posts in this series include: Uncle Sam’s Growing Investment Portfolio and Uncle Sam’s Trillion-Dollar Portfolio Partly Offsets the Public Debt.

Sources: Monthly Statement of Public Debt, Federal Reserve’s Financial Accounts of the United States, and Federal Reserve’s Factors Affecting Reserve Balances.

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When policy folks talk about America’s federal borrowing, their go-to measures are the public debt, currently $12 trillion, and its ratio to gross domestic product, which is approaching 75 percent. Those figures represent the debt that Treasury has sold into public capital markets, pays interest on, and will one day roll over or repay.

These debt measures are important, but they paint an incomplete picture of America’s fiscal health. They don’t account for the current level of interest rates, for example, or for the trajectory of future revenues and spending. A third limitation, the focus of this post, is that the public debt doesn’t give Treasury any credit for the many financial assets it owns.

As we noted last week, Uncle Sam has been borrowing not only to finance deficits but also to make student loans, build up cash, and buy other financial assets. That portfolio now stands at $1.1 trillion, equivalent to almost one-tenth of the public debt.

Those assets have real value. They pay interest and dividends and could be sold if Treasury ever cared to. In fact, Treasury has sold many financial assets in recent years, including mortgage-backed securities and equity stakes in TARP-backed companies, even as it expanded its portfolio of student loans.

Debt Measures

One way to take account of these holdings is to subtract their value from the outstanding debt. The rationale is straightforward. If Ann and Bob each owe $30,000 in student loans and have no other debts, they both have the same gross debt. But that doesn’t mean their financial situations are the same. If Ann has $10,000 in the bank and Bob has only $5,000, then Ann is in a stronger position. Her net debt is $20,000, while Bob’s is $25,000.

The same logic applies to the federal government: $12 trillion in debt is easier to bear if the government has some offsetting financial assets than if it has none. That’s why both the Office of Management and Budget and the Congressional Budget Office regularly report the public debt net of financial assets. The net debt isn’t a perfect measure; many assets are harder to value than Ann and Bob’s bank accounts, and official valuations may not fully reflect their risk. Nonetheless, as CBO has said, the net public debt provides “a more comprehensive picture of the government’s financial condition and its overall impact on credit markets” than does the gross public debt.

The net debt is now a bit less than $11 trillion or about 68 percent of GDP. That’s more than $1 trillion less than the usual, gross measure of public debt, or about 7 percent of GDP. That difference was only 3 percent of GDP as recently as 2006. Under President Obama’s budget, it would expand to almost 10 percent by 2023, with financial assets growing twice as fast as the public debt.

Financial assets are thus playing a bigger role in America’s debt story. Accumulating deficits remain the prime driver of the debt. But the expansion of Uncle Sam’s investment portfolio means the growing public debt overstates America’s debt burden.

This post was coauthored by Hillel Kipnis, who in interning at the Urban Institute this summer.

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The federal government has been borrowing rapidly to finance recent budget deficits. But that’s not the only reason it’s gone deeper into debt. Uncle Sam also borrows to issue loans, build up cash, and make other financial investments.

Those financial activities have accounted for an important part of government borrowing in recent years. Since October 2007, the public debt has increased by $6.9 trillion. Most went to finance deficits, but about $650 billion went to expand the government’s investment portfolio, including a big jump in student loans. Before the financial crisis, Uncle Sam held less than $500 billion in cash, bonds, mortgages, and other financial instruments. Today, that portfolio has more than doubled, exceeding $1.1 trillion:

Uncle Sam Investment Portfolio

Financial crisis firefighting drove much of the increase from 2008 through mid-2010. Treasury raised extra cash to deposit at the Federal Reserve; this Supplemental Financing Program (SFP) helped the Fed finance its lending efforts in the days before quantitative easing. Treasury placed Fannie Mae and Freddie Mac, the two mortgage giants, into conservatorship, receiving preferred stock in return; shortly thereafter, Treasury began to purchase debt and mortgage-backed securities (MBS) issued by Fannie, Freddie, and other government-sponsored enterprises (GSEs). And through the Troubled Asset Relief Program (TARP), Treasury made investments in banks, insurance companies, and automakers and helped support various lending programs.

Together with a few smaller programs, these financial crisis responses peaked at more than $600 billion. Since then, they have declined as Treasury sold off all its agency debt and MBS and most of its TARP investments and as quantitative easing, in which the Fed simply creates new bank reserves, eliminated the need for cash raised through the SFP.

Those declines have been more than offset by the government’s growing student loan portfolio. The federal government used to subsidize student borrowing not only by providing loans directly to students, but also by guaranteeing many private loans. In 2009, however, Congress eliminated private guarantees and dramatically expanded direct federal lending. The government’s portfolio of student loans has since increased from about $90 billion at the start of fiscal 2008 to more than $560 billion today.

As a result, the government’s financial investments now total about $1.1 trillion, essentially all of which was financed by borrowing. The debt supporting Uncle Sam’s investment portfolio thus accounts for almost 10 percent of the $11.9 trillion in public debt.

Source: The Federal Reserve Financial Accounts (formerly known as the Flow of Funds), Daily Treasury Statement, and the President’s Budgets. The figures here compare balances as of March 31, 2013 (most recent available) with balances as of September 30, 2007 (the end of fiscal 2007). We define financial investments to be all the federal government’s financial assets except for official reserve assets, trade receivables, and tax receivables; this definition approximates those used by the Office of Management and Budget and the Congressional Budget Office in certain debt calculations.

This post was coauthored by Hillel Kipnis, who in interning at the Urban Institute this summer.

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Sweden is rightly admired for the way it handled its banking crisis in the early 1990s (and its ensuing fiscal challenges).

In yesterday’s Financial Times, Dag Detter looks back for some lessons for Europe as it struggles to resolve its current banking crisis:

When the Swedish banking system crashed in 1992, the government faced an  identical problem. Yet in the end, Sweden’s taxpayers came very well out of  their experience of bank ownership. How was this achieved, and what lessons can  be learnt for Madrid and the EU’s new bank resolution policy?

First, move fast. Spain and bankers have  been in denial about the scale of bad lending for too long. The Rajoy  government rightly came to office this year on a promise to force banks to write  down bad loans. The situation has predictably turned out to be much worse than  assumed, but their policy is the right one. Painful as it is, transparency on  the scale of bad debt is vital for the market to be confident that it  understands risk and uncertainty  in Spain and can therefore price it properly.

Catharsis can come only with a purge of bad assets. Banks should present  plans to handle problem assets, strengthen controls and improve efficiency. This  might require government or even supranational assistance in the orderly closure  of moribund institutions. In addition, “bad” bank parts must be demerged from  the “healthy” to facilitate recapitalisation. The state should never be left  holding the junk while the healthy part of a bank wriggles free.

Second, maintain commercial principles. In Sweden, each state bank investment  was made on what would have been commercial terms in a normal market, always  with the aim of maintaining competitive neutrality. The terms of the investment  must be structured in a way that gives the bank and its owners no grounds to  request more state funding than is necessary, combined with the incentives to  facilitate a swift exit. Yet it must be sufficient to ensure that the bank can  return to profitability without additional government assistance.

The whole piece is worth a read.

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“American investors lack basic financial literacy,” according to a new report from the Securities and Exchange Commission (much of which is based on an earlier report by the Congressional Research Service at the Library of Congress). Many fail to grasp compound interest, don’t understand fees and other investment costs, and aren’t aware about the risks of investment fraud.

From the report summary:

According to the Library of Congress Report, studies show consistently that American investors lack basic financial literacy. For example, studies have found that investors do not understand the most elementary financial concepts, such as compound interest and inflation. Studies have also found that many investors do not understand other key financial concepts, such as diversification or the differences between stocks and bonds, and are not fully aware of investment costs and their impact on investment returns. Moreover, based on studies cited in the Library of Congress Report, investors lack critical knowledge about investment fraud. In addition, surveys demonstrate that certain subgroups, including women, African-Americans, Hispanics, the oldest segment of the elderly population, and those who are poorly educated, have an even greater lack of investment knowledge than the average general population. The Library of Congress Report concludes that “low levels of investor literacy have serious implications for the ability of broad segments of the population to retire comfortably, particularly in an age dominated by defined-contribution retirement plans.”

The report goes on to discuss ideas for increasing financial literacy and increasing the transparency of fees and other investment costs.

People sometimes talk about financial literacy as though the goal is helping people choose their own investments. That can be helpful, but the report rightly discusses another goal: improving consumers’ ability to work with financial advisors.

P.S. For a brief discussion of financial literacy and mortgages, see this post from 2010.

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The Rise of Trading Quote Spam

On Monday, I posted a lovely animated gif from Nanex showing the rise of high-frequency trading. What I failed to mention is that graph doesn’t show completed trades. It shows quotes.

And according to another nice chart from Nanex, it’s high-frequency quoting that has skyrocketed (left chart), not trading (right):

As Nanex explains:

Each day is plotted in a separate color over the course of a trading day (9:30 to 16:00 Eastern): older data uses colors towards the violet end of the spectrum, recent data towards the red end of the spectrum. The gaps you see between color groups on the quote chart (left-side) is when system capacity was upgraded to handle the increase in traffic, and quote spam jumped to fill the new capacity that very same day.

The number of unexecuted quotes, many allegedly not intended to be executed, has thus skyrocketed.

France recently took steps to try to deter the rise in quotes. In addition to a financial transactions tax it, France will also impose a tax on traders who submit too many unfilled quotes.

In short, France will levy a financial non-transaction tax.

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High frequency trading (HFT) has taken off like wildfire in recent years. Nowhere is that better illustrated than in this stunning animated GIF from Nanex, a provider of streaming market data (ht: Felix Salmon).

The gif shows the rise in HFT or algorithmic trading from 2007 through early 2012. It doesn’t capture last week’s meltdown at Knight Capital, but you can see many other seminal events of recent years.

I find it strangely beautiful, like watching a fire build.

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