Dec 27, 2013

After the Greenspan put: new market insurance

With the passage of far-reaching regulatory reforms following the 2008 financial crisis, there has matured a view in the policy circles that asset bubbles should be suppressed by targeted regulatory approaches, without resorting to contractionary monetary policy, that needlessly slows down the entire economy.

Indeed, in the past, the US has successfully employed tailored regulatory methods in limiting the buildup of bubbles. In the 1940s and 50s, for example, the government effectively suppressed excessive real estate price inflation by imposing more stringent loan underwriting standards. In another example, the Federal Reserve had increased margin requirements on stock purchases from 40% to 100% in order to restrain the unjustifiably rapid increase in stock market prices in 1945. While the stock market continued rising, the amount of stocks traded on margin was sharply reduced, hence taking some heat out of stock speculators.

Dec 26, 2013

Next Trojan horse

1. Cash pools in money markets

Specifically, in the markets of repurchase agreements (repos), reverse repos, securities lending and borrowing, and securities margin lending.

As described in the article on the "equally safe" phenomenon (VLTCM, 2013), cash pools will again play a central role in the next financial crisis, as their withdrawal turns troubled and illiquid institutions into insolvent ones virtually overnight. Cash pools possess the most vivid Trojan horse characteristic, as they evaporate without any prior indication, unexpectedly to everyone.

Dec 25, 2013

Flow of funds

Great novelists possess a talent for capturing the very essence of the times in which they live. Theodore Dreiser was one of those geniuses. In his novel The Financier, Dreiser was able to identify the most important indicator in the world of finance. Dreiser's financier "understood finance accurately. The meaning of gold shipments was clear. Where money was going trade was - a thriving, developing life" (Dreiser, 1912). Today these thoughts are as relevant as ever.

The 2008 financial crisis represents a good illustration of the importance of fund movements. In the years leading to the crisis, the flow of funds that poured into highly secure long-term and short-term assets was a key indicator of the upcoming market collapse.

Dec 24, 2013

Watch for the conductor, not the musicians

Unlike in the early years of the 20th century, when one man, named J.P. Morgan, ruled the world of finance and was able to use his power to save financial markets from a collapse in 1907, today's highly complex and interconnected financial system does not dance to the tune of a single individual or institution. Instead, the modern financial system is reminiscent of a band of musicians that consists of the first violin and other performers. At times, however, one of the musicians puts his violin or contrabass away and assumes the role of a conductor. When that happens, the system becomes highly prone to financial calamities.

Up until the 2008 financial crisis, the role of a conductor was played by big US investment banks. These investment banks pooled interests of multiple constituents together: investors on supply side - namely, holders of cash pools; investors on the demand side - virtually every imaginable institutional investor; and other participants - credit agencies, insurance companies, commercial banks, and legislators in Washington. The investment banks were able to satisfy everybody – from ultimate borrowers, such as households, nonfinancial firms, and governments to ultimate savers, such as cash-rich corporations, asset managers, and securities lenders, to investors, such as hedge funds and foreign investment firms. The investment banks were able to beautifully orchestrate this intermediation network and profit from it enormously. On the flip side, the crisis would not have happened in the first place, if it was not for the investment banks assuming the role of a conductor.

Dec 23, 2013

Make your money (and your financial advisor) work for you

In 1852, young John Davison Rockefeller, the future founder of the Standard Oil Company, took on a ten-hour workday job digging potatoes for a local farmer. As Rockefeller soon calculated, he "could get as much interest for fifty dollars loaned (to a bank) ... as (he) could earn by digging potatoes for 100 days." (Tarbell, 2010). He added that "the impression was gaining ground with me that it was a good thing to let the money be my slave and not make myself a slave to money" (Tarbell, 2010).

Today we seem to forget this sound advice. We entrust our capital to a financial advisor, and he merely tells us about the benefits of diversification, which can be read about in hundreds of books and websites; builds a stock and bond portfolio for us using software, which will be available for free download in a few years, if not already now; optimizes our taxes, assures us that everything is good, and perhaps makes a return on our portfolio, although this accomplishment does not depend on the advisor's skills, but on the market performance and the precision of investment analysts' forecast reports the advisor reads for us. No doubt that in the eyes of Mr. Rockefeller, this would have been a rather poor return on capital.

Dec 22, 2013

How to identify the "equally safe" phenomenon

The "equally safe" phenomenon is not new to financial systems. Hence, the question is not whether "equally safe" instruments1 exist per se, but whether they are misused since misusage leads to crises. To identify whether equally safe instruments are misemployed, they should be examined from two sides - supply and demand.

From the supply side, we need to understand (1) how much cash is supplied today in comparison to recent history. Oversupply of cash makes investors go on an investment spree, creating a bubble. At a minimum, we should track the total amount of cash invested into equally safe instruments and compare it to historical levels, both in absolute and relative terms. A relative comparison can be gauged by a ratio of cash invested in equally safe instruments to the balance sheet size of the financial firms that end up using the cash.

Dec 17, 2013

The "equally safe" phenomenon

In the 2007-2008 financial crisis, institutional investors found out that investing in money markets, particularly in repurchase agreements and commercial paper, was not nearly as safe as depositing money in a bank account or acquiring short-term US Treasury securities; although prior to the crash, these four types of instruments were generally deemed of equivalent safety. This is not the first time in financial history when seemingly safe and liquid instruments take a free ride on commercial banks' and government securities' reputation for solidity, ultimately causing major financial crises. Some of the most noteworthy examples are presented here. The structure of this analysis is as follows:

2008 financial crisis
1975 British secondary banking crisis
1907 panic on Wall Street
1929 Wall Street crash
1866 panic in the UK
1763 panic in Netherlands
Conclusion
Appendix: Summary of panic origins