Financial Stress, Financial Regulation and In the Medium Run, We Are All Bankrupt

Financial Stress, Financial Regulation and In the Medium Run, We Are All Bankrupt
Carlos M. Pelaez

The objective of this post is to analyze continuing stress in financial variables. Section I documents financial stress and its causes; bank stress tests are considered in II; financial regulation is analyzed in III; the postponement of fiscal adjustment to the medium run, when we are all bankrupt, is considered in IV; economic indicators are documented in V and interest rates in VI; and VII concludes.
I Financial Stress. World financial markets continue showing signs of stress. (1). Stocks. The major stock indexes have declined from the recent peak in April but most gained during the week ending on Jun 18. The Global Dow declined from the recent peak on Apr 15 by 12.6 percent but gained 3.3 percent in the week (http://online.wsj.com/mdc/public/page/mdc_international.html?mod=topnav_2_3002 ). The DJ Asia Pacific TSM declined by 9.4 percent from the recent peak on Apr 15 but gained 3.3 percent in the week. The Shanghai Composite declined by 20.6 percent from the recent peak on Apr 15 and also declined by 2.2 percent in the week. US stock indexes are still below the recent peak on Apr 26, the DJIA by 6.7 percent and the S&P 500 by 8.2 percent, but both gained in the week, the DJIA by 2.3 percent and the S&P 500 by 2.4 percent. The NYSE Financial index fell by 15.8 percent from the recent peak and by 3.2 percent in the week. (2). Currencies. The strength of the euro has been a barometer of economic and financial conditions in Europe. The dollar appreciated by 22.1 percent from Nov 25, 2009, to Jun 18 but depreciated by 2.3 percent since Jun 11. (3). Commodities. The DJ UBS commodity index declined by 11.4 percent from Jan 6 but gained 2.7 percent in the week. Crude oil traded at $77.35/barrel on Jun 18, recovering from the recent low below $69/barrel but copper traded at 291.75 cents/pound below 300 cents/pound. (4). Financial Risk. Libor has remained unchanged at 0.539 after jumping to a level twice higher than before the euro crisis. The dollar LIBOR-OIS spread, which measures the willingness of banks to lend, has remained at 31.94 basis points (bps) after jumping from 9 bps in the first three months of the year but still substantially lower than 364 bps in Sep 2008 (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aqE6cujZAPAA ). LIBOR is critically important because it is the reference index of about $360 trillion of financial assets worldwide (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aI9wAS.ZMFLU ).
The recovery of financial variables on Jun 15 was quite strong (http://professional.wsj.com/article/SB10001424052748704009804575308241077366122.html?mod=wsjproe_hps_LEFTWhatsNews ). All US stock indexes had strong gains: 2.1 percent for the DJIA, 2.4 percent for the S&P 500 and 2.8 percent for the Nasdaq Composite. Oil futures approached $77/barrel. The successful placement of debt by Spain and Belgium strengthened the euro above $1.23/EUR. Global financial stress originates in the incidence and interrelation of four sources of vulnerabilities. First, China’s GDP has been growing since 1979 at rates at least above 6 percent and in many years at 10 percent or higher (Pelaez and Pelaez, The Global Recession Risk, 80). Tighter monetary policy to control rising property values could reduce the rate of growth of China that would lower demand for industrial commodities, causing decline in their prices. There may be more merit in explaining the surge of commodity prices in the carry trade of shorting the dollar and buying commodity futures that has been induced by the zero interest rate on fed funds (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The rise of oil to $149/barrel in 2008 during a major world crisis can only be explained by carry trade positions; the decline to less than $60/barrel can only be explained by the unwinding of those positions. Fear of regulatory shocks on oil futures moved substantial part of the carry trade to gold. The zero interest rate distorts financial and economic decisions on risks and rewards. Another important effect of the decline of China’s growth would be in the form of deceleration of other Asia Pacific economies because of the importance of interregional trade. The rise of US equities markets on Jun 15 and the strengthening euro caused the increase in Asian equities when markets opened because of the hopes that US growth would provide demand for Asia’s exports. There were sharp increases in equities of exporters and the equity indexes increased by 1.8 percent in Japan, 0.9 percent in South Korea, 1.2 percent in Australia and 1 percent in Indonesia and Singapore (http://professional.wsj.com/article/SB10001424052748704009804575309503381564996.html?mod=wsjproe_hps_LEFTWhatsNews ). Manufacturing and world trade have been leading the world economy out of the recession with trade among Europe, the US and Asia being of critical importance. It is not likely that revaluation of the renminbi will have major repercussions in the economies of China, Europe and the US because there were not many effects from the prior 20 percent revaluation. However, the announcement by China on Saturday of abandoning the peg of its currency to the dollar may contribute to at least temporary stability in currency and financial markets (http://www.ft.com/cms/s/0/ac0ca08e-7ba7-11df-aa88-00144feabdc0.html http://www.pbc.gov.cn/english/detail.asp?col=6400&id=1488 ). It may also help to avoid an adverse trade confrontation among nations. Second, the recovery of financial markets during the week also proved again the key importance of recovery of Europe from the sovereign risk issues as well as the strengthening of the European banking system. Third, the most threatening event is still dormant in the form of unsustainable US budget deficits and government debt. Fourth, global financial regulation, especially in the US, is adding to stress in bank equities at the wrong time.
II Bank Stress Tests. The European Central Bank (ECB) provided EUR85.6 billion to Spanish banks, or twice the level during the Lehman Bros demise in Sep 2008, representing 16.5 percent of ECB’s net lending to the euro zone (http://www.ft.com/cms/s/0/8eb0eeda-78de-11df-a312-00144feabdc0.html ). The Financial Times quotes estimates of the Royal Bank of Scotland of foreign-held liabilities of Spain reaching $1.8 trillion, which is equivalent to 142 percent of the country’s GDP, and EUR770 billion in the form of liabilities of Spanish banks (http://www.ft.com/cms/s/0/a4bfc6ec-79a6-11df-85be-00144feabdc0.html ). European banks had record deposits of EUR364.6 billion or $369 billion deposited at the European Central Bank (ECB), earning the low 0.25 percent rate of the deposit facility (http://www.ft.com/cms/s/0/1f922206-73ea-11df-87f5-00144feabdc0.html ). Deposits of banks at the ECB in the eight years before the demise of Lehman Bros averaged about EUR277 million (http://www.bloomberg.com/apps/news?pid=20601109&sid=aHl8DzEheXq8&pos=15 ). Banks are funding with short-term ECB loans and interbank funding for one month. The 96 bidders of 7-day loans at the ECB borrowed EUR122 billion at the rate of 1 percent on Jun 8, which is about triple that of the euro interbank offered rate of 0.37 percent (Ibid). The ECB announced on May 31 that write downs of European banks in 2011 will reach EUR195 billion in addition to EUR440 billion already taken for a total of $762 billion (Ibid). The initial sovereign risk issues in Europe have evolved into concerns about the strength of the banking system. The leaders of the European Union announced on Jun 18 that 26 banks will publish stress tests in July in an effort to recover confidence in banks and financial markets in general (http://www.ft.com/cms/s/0/32b9658c-7afd-11df-8935-00144feabdc0,dwp_uuid=79cadde4-5c1b-11df-95f9-00144feab49a.html ). Stress tests are part of an arsenal of tools used by financial institutions in processes of risk management (Pelaez and Pelaez, Globalization and the State, Vol. I, 78-100, Government Intervention in Globalization, 63-4, International Financial Architecture, 112-6). Financial markets were still fractured before Mar 2009. The US engaged in stress tests of major banks and subsequent public disclosure (Pelaez and Pelaez, Financial Regulation after the Global Recession, 164, 170, Regulation of Banks and Finance, 226, 231). Criticism of banks on alleged lack of understanding of complex products by most everybody is unwarranted. Most travelers do not have knowledge of how jet planes function but benefit from rapid transportation worldwide. Accidents occur because of the limitations of human knowledge. The problems with structured products originated in policies that effectively replicated the cash flows of writing by the government of a put option on house prices that could eventually not be honored (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). A jet plane requires high-grade fuel much the same as structured products cannot function properly with referenced unsound mortgages created by policy exuberance in the form of financing of everything at near zero interest rates of fed funds and purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie. The partial costs to taxpayers of bailing out Fannie and Freddie are now estimated to be at least $160 billion but could reach as much as $1 trillion, without any provision in financial regulation laws (http://www.bloomberg.com/apps/news?pid=20601109&sid=an_hcY9YaJas&pos=10 ). Financial institutions have been performing stress tests or the use of multiple technical methods in calculating potential effects on values of exposures resulting from exceptional but still possible events. Stress tests attempt to measure what would happen to banks’ viability in case of wide swings of risk factors. The critical issue in the European bank stress-test exercises is whether the banks are sufficiently capitalized to take a hit on their capital originating in wide swings in variables that affect their risk exposures. At the extreme, stress tests can prove that almost any bank can disappear with wild shocks of financial variables even with Tier 1 capital above that proposed in Basel III, while stress testing with benign shocks of variables may not be convincing. Banks conduct regular stress tests that they share with regulators and the likely direction of the new stress tests is probably already known now instead of by the disclosure date in July. The outcome of the exercise is highly dependent on how financial stress evolves in the next months because under higher confidence weak results of stress tests could be dismissed by market participants.
III Financial Regulation. Crises are not opportunities for financial regulation. The Glass-Steagall Act of 1933 was proposed on the basis of alleged conflicts of interest of commercial banks in the form of unloading their bad loans by placing unsound securities with investors that have been disproved by well-established facts (see work by Randall Kroszner and Raghuram Rajan and vast literature cited in Pelaez and Pelaez, Globalization and the State Vol. I, 48, Government Intervention in Globalization, 45 Financial Regulation after the Global Recession, 91-101 and Regulation of Banks and Finance, 121-9). The current rush to regulation is similar to that in the 1930s that has been demystified by more careful technical work. The merging process of the inopportune House and Senate financial bills still struggles with issues that had nothing to do with the causes of the credit/dollar crisis and global recession or with any other alleged benefit of stability and efficiency in finance. The spinoff of swap derivatives desks of banks will be very costly to banks (http://professional.wsj.com/article/SB10001424052748703685404575307042349354142.html?mod=wsjproe_hps_LEFTWhatsNews ), increasing risks that could not be hedged with adverse instability effects, exporting the financial industry to other jurisdictions and harming the general public. Amputations of bank activities that have never posed risk, such as in the Volcker Rule, may unsettle currently viable institutions that could become unviable after regulatory surgery. The entire system may become crisis-prone by concentration of activities in credit instead of diversification that helps to soften cyclical impacts. US banks will become uncompetitive and unable to finance the international operations of US firms and large domestic projects required for growth of the American economy. Bulk financing of factories is required to create jobs that provide income for building of homes and financing investment in education. A more politicized Fed will be the result of subjecting to politics the 12 regional Federal Reserve Banks that have been independent for 97 years (http://professional.wsj.com/article/SB10001424052748704575304575297130299281828.html ). Government-owned and controlled banks have been more unstable and inefficient (Pelaez and Pelaez, Regulation of Banks and Finance, 227-9). The UK regulatory reform, while ambitious, is being more pragmatic than in the US, proceeding with careful review that will allow banks to recover before actual implementation of new regulation (http://professional.wsj.com/article/SB10001424052748704198004575310451098811086.html?mod=wsjproe_hps_LEFTWhatsNews ). US regulation will sharply increase bank costs, squeezing profits and capital. The general effect will be lower volume of financing and higher interest costs. Banks will find themselves in the difficult position of raising fees in the effort to avoid higher hits on their operations (http://professional.wsj.com/article/SB20001424052748703513604575311093932315142.html ). The message of the US to the G20 consists of: “stronger oversight of derivatives markets, more transparency and disclosure and more effective framework for winding down large global firms” (http://www.whitehouse.gov/sites/default/files/rss_viewer/president_obama_letter_to_g-20_061610.pdf ). The House and Senate bills have arbitrary provisions that jeopardize functions of financial institutions and markets with unknown but likely adverse effects of the entire bill, which defies technical analysis and experience. Financial regulation may restrict growth and recovery by contracting credit and increasing borrowing costs.
IV In the Medium Run, We Are All Bankrupt. The message of the US to the G20 identifies the top priority “to safeguard and strengthen the recovery,” calling for “unity of purpose to provide the policy support necessary to keep economic growth strong” (http://www.whitehouse.gov/sites/default/files/rss_viewer/president_obama_letter_to_g-20_061610.pdf ), which can be interpreted as “continued stimulus” or higher expenditures (http://www.businessweek.com/news/2010-06-18/obama-tells-g-20-to-strengthen-economic-recovery-update4-.html ). At the same time, the US message pleads for commitment “to fiscal adjustment” to stabilize “debt-to-GDP ratios at appropriate levels over the medium term” (http://www.whitehouse.gov/sites/default/files/rss_viewer/president_obama_letter_to_g-20_061610.pdf ). The famous phrase of John Maynard Keynes “in the long-run, we are all dead” in the Tract on Monetary Reform means to Keynesians that we live in the short run (http://www.econlib.org/library/Enc/KeynesianEconomics.html ). The current agenda is geared to alleged benefits of restructuring the economy toward the very long run. The delay of the control of the budget deficit and debt to the “medium term” may have the meaning of a new phrase: “in the medium run, we are all bankrupt.” The International Monetary Fund (IMF) projects the general government gross debt of the US at 92.6 percent in 2010, rising to 109.7 percent in 2015 and the general government net debt at 66.2 percent in 2010, rising to 85.5 percent in 2015. In 2008, the government gross debt was 70.6 percent of GDP and the government net debt was 47.2 percent of GDP (http://www.imf.org/external/pubs/ft/weo/2010/01/weodata/weorept.aspx?sy=2008&ey=2015&scsm=1&ssd=1&sort=country&ds=.&br=1&c=156%2C158%2C132%2C112%2C134%2C111%2C136&s=NGDP%2CGGXWDN_NGDP%2CGGXWDG_NGDP%2CNGDP_FY&grp=0&a=&pr1.x=59&pr1.y=15 ). The risk of a US debt stress event is that markets may discount to present value or current prices of financial assets the future consequences on risk, production and output of an unsustainable government debt.
V Economic Indicators. Manufacturing continues to lead the recovery of the US economy and inflation is subdued while housing and employment remain doubtful. The Empire State Manufacturing Survey of the New York Federal Reserve Bank finds improving conditions in Jun for the eleventh consecutive month (http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html ). The Philadelphia Fed Business Outlook Survey finds that manufacturing is expanding in Jun but at slower rhythm than in May; manufacturing executives continue to expect growth in business in the next six months (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0610.cfm ). The index of industrial production of the Fed finds an increase of industrial production in May of 1.2 percent after an increase in Apr of 0.7 percent; manufacturing increased 0.9 percent in May, standing higher than a year ago by 7.9 percent. Capacity utilization for total industry increased by one percentage point to 74.7 percent, which is higher by 6.2 percentage points than a year earlier but is still 5.9 percentage points below the average for 1972-2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm ). The producer price index for finished goods fell 0.3 percent in May and is higher by 5.3 percent in the 12 months ending in May (http://www.federalreserve.gov/releases/g17/Current/default.htm ). The consumer price index fell 0.2 percent in May and increased by 2.0 percent in the 12 months ending in May (http://www.bls.gov/news.release/pdf/cpi.pdf ). The US current account deficit rose from a revised $100.9 billion in the fourth quarter of 2009 to $109.0 billion in the first quarter of 2010. The deficit was the third consecutive quarterly increase since the second quarter of 2009 when the deficit was $84.4 billion, which was the lowest since the third quarter of 1999 (http://www.bea.gov/newsreleases/international/transactions/transnewsrelease.htm ). Simple extrapolation of the deficit for the year of $436 billion is equivalent to about 3 percent of the CBO estimate of 2010 GDP of $14,706 billion (http://www.cbo.gov/ftpdocs/108xx/doc10871/01-26-Outlook.pdf ), which is significantly lower than predictions of two-digit current account deficits as percent of GDP before the credit crisis (Pelaez and Pelaez, The Global Recession Risk, 20-55). Housing recovery may be slow and prolonged. In Jan 2006, housing starts in the US were at an annual rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). In May 2010, housing starts were at an annual rate of 574 thousand, higher by 4.4 percent over a year earlier but 74.7 percent below the level in Jan 2006 (http://www.census.gov/const/newresconst_201002.pdf ). New unemployment insurance claims rose by 12 thousand in the week ending on Jun 12, reaching 472 thousand relative to 460 thousand in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
VI Interest Rates. The use of Treasuries as intermediate safe haven for risk positions has resulted in the decrease of the yield of the 10-year Treasury from 3.986 percent on Apr 5 to 3.145 percent on Jun 7, 3.239 percent on Jun 11 and 3.225 per cent on Jun 18 (http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3000 ). The yield curve is now almost undistinguishable over the past month with the 10-year Treasury almost equal at 2.23 percent from the level a week ago at 3.22 percent and 3.25 percent a month ago (http://markets.ft.com/markets/bonds.asp ). The German 10-year government bond traded on Friday at 2.73 percent for a negative spread of 50 bps relative to the comparable Treasury.
VII Conclusion. There are significant uncertainties in Asia, Europe and the United States that cause stress of financial variables. The regulatory shock in the US constitutes a threat to financial stability, economic recovery and employment creation. The unsustainable government debt of the US may translate into a new phrase that “in the medium run, we are all bankrupt.” (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )