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.

Demand for highly safe, long-term, American assets started with the massive accumulation of capital in Asia, the Middle East - cumulatively called "the global saving glut" (Bernanke, 2005), and Europe. Specifically, Asian investors hoarded cash instead of investing domestically as a consequence of the scalding experiences of the 1997-98 Asian financial crisis; Middle Eastern nations accumulated large reserves thanks to surplus revenues from oil and commodity sales; and European countries issued massive amounts of sovereign and bank debt that filled their coffers in excess of what they needed. This capital then flowed to the US and bought up 55% of all highly rated long-term assets, including Treasury bonds, agency securities, and highly rated structured products (Bernanke, Bertaut, DeMarco, Kamin, 2011).

Long-term secure assets are important in the world of a market-based financial system, such as the one in the US, because they are used as collateral for financial transactions. For example, when cash-rich lenders lend their cash in money markets, highly rated collateral serves as a guarantee for them.

However, because of the acquisitions made by foreign investors, a shortage of high-quality collateral started to appear. Meanwhile, idle cash was sitting on the books of cash-rich lenders and waiting to be invested in money markets, but refraining from doing so due to the lack of suitable collateral. This condition caught the eye of Wall Street financiers, who gladly launched the subprime securitization machine to accommodate the need of cash-rich lenders for highly rated collateral. The financiers took prime and subprime mortgages and turned them into structured products. A Faustian bargain was then arranged with credit agencies that convinced the investment public that structured products possessed the same safety level as Treasury securities. Recognizing that their transactions were now backed by collateral of the required quality, cash-rich lenders went ahead with the lending.

That is where the story of another type of funds - funds that demand short-term assets - began. Funds that seek short-term investments are the most liquid, as they can come today and leave tomorrow; nothing constraints their movement, and yet everything alarms them. These funds always fall into the trap of the "equally safe" phenomenon (see VLTCM, 2013), and often end up being the root cause of financial crises, as was the case in the 2008 financial crisis, the highly similar secondary banking crisis in the UK in 1973-75, the 1929 Wall Street crash, the 1907 panic on Wall Street, ... the list goes on to ancient Greece, where a Greek merchant lent gold coins to another trader with the right to request the money back upon a one day notice.

Funds that seek short-term investments are the most liquid, as they can come today and leave tomorrow; nothing constraints their movement, and yet everything alarms them. These funds...often end up being the root cause of financial crises, as was the case in...ancient Greece, where a Greek merchant lent gold coins to another trader with the right to request the money back upon a one day notice.

Understanding how much and whose capital flows where is equivalent to knowing the future. Keeping a constant hand on the pulse of the flow of funds, that seek both long-term and short-term investments, is one of the key skills of a very LT investor. The fact that a typical professional investor does not read, or even know how to read, the Fed's flow of funds accounts - the most accessible data on money flows in the economy, should further motivate a very LT investor to keep track of "where money was going" (Dreiser, 2008).









Sources

Bernanke, B. (2005, March). The Global Saving Glut and the U.S. Current Account Deficit. Speech presented at Virginia Association of Economists, Richmond, VA.

Bernanke, B., Bertaut, C., DeMarco, L., & Kamin, S. (2011). International Capital Flows and the Returns to Safe Assets in the United States, 2003-2007. (International Finance Discussion Papers Number 1014). Washington, D.C.: Board of Governors of the Federal Reserve System.

Dreiser, T. (1912). The Financier. New York, NY: Harper & Brothers.

VLTCM (2013). The "equally safe" phenomenon.

1 comment:

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