New Fed paper: Liquidity, Monetary Policy, and Financial Cycles

graphrix_IHB

graphrix_IHB

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<a href="http://www.newyorkfed.org/research/current_issues/ci14-1.pdf">Here is the current issues paper from the NY Fed</a>.





<em> A close look at how financial intermediaries manage their balance sheets suggests that these institutions raise their leverage during asset price booms and lower it during downturns—pro-cyclical actions that tend to exaggerate the fluctuations of the financial cycle. The authors of this study argue that the growth rate of aggregate balance sheets may be the most fitting measure of liquidity in a market-based financial system. Moreover, the authors show a strong correlation between balance sheet growth and the easing and tightening of monetary policy.</em>





Very interesting read, and great chartporn.





Opinions, questions, rants, and general discussion is welcome...
 
Reading technical papers does my head in sometimes...





I don't fully understand how this works: "A closer look at the fluctuations in balance sheets reveals that the chief tool used by institutions to adjust their leverage is collateralized borrowing and lending—in particular, repurchase agreements (repos) and reverse repurchase agreements (reverse repos), transactions in which the borrower of funds provides securities as collateral."





Since I don't fully understand how this mechanism works, I really don't understand the rest of the paper...





I do not find it surprising that banks loan more money during expansions and less money during contractions. During expansions, money needs to be put to work, and during contractions, money needs to be held in reserve. This is pro-cyclical, and it should be. It seems the authors find this concept revelatory. I don't know why. Also, this pro-cyclical nature of lending and the credit cycle does make expansions go on too long and make contractions deeper. This is just the nature of the credit cycle. Is the authors intent to disrupt this cycle and "smooth things out?" Good luck with that.





I also don't fully understand the callout box "The Link between Monetary Policy and the Growth of Repos" The equations and the Taylor rule residual were over my head. I guess I need to learn more about monetary policy.
 
<p>Not sure how valuable this study is. Its definition of US financial intermediary only includes the traditional US banks and investment banks. The shadow banking system (unregulated hedge funds) has played an as large if not larger role than the traditional financial intermediary in providing liquidity. Yet, the fed insists on not regulating them. Why?</p>
 
How would you regulate a hedge fund? Basically, a hedge fund is just a company that makes its money by trading in securities or holding assets for cashflow. Many large corporations do this, but not as their primary business, so it would be very difficult to define what a hedge fund is to subject it to regulation. I don't disagree that their activities should be subject to more rigorous examination and possibly regulation, I just think it might be very difficult to enforce.





On your larger point about the study failing to look at this part of the system, I agree, it does leave off a significant player in the game and thereby makes their conclusions suspect.
 
<p>Good point, IrvineRenter.</p>

<p>I know next to nothing about how to govern or regulate. I do think they need to start somewhere. One possible idea to regulate the hedge funds, is to define and create a sub-sector within the Investment Company Act of 193X. I think any entity created for the sole purpose of making investments in securities and their derivatives, should be considered.</p>
 
hedge fund registration with the SEC was supposed to begin on feb 1, 2006 but was subsequently overturned by Goldstein vs SEC in june of that year. a hedge fund is not a very specific entity nor are the types of investments they make. many hedge funds are involved in exotic derivatives, jvs, and other sort of investments that may mimic traditional securities but are completely outside the jurisdiction of the SEC. is an investment club with more than 15 members a hedge fund? a family office? and what about PE firms? why regulate a hedge fund that buys 5% of shares in a company, but not a private equity firm which buys 51% of the company?



i dont disagree with the intent of what the SEC was attempting to do, but how exactly it will be executed will be extremely difficult.
 
<p><em>is an investment club with more than 15 members a hedge fund? a family office? </em></p>

<p>Most of them don't , but if an investment club uses a prime brokerage account and has access to any loan other than regular margin loan (fed regulated), then I would like to think yes.</p>

<p><em>and what about PE firms?</em></p>

<p>I don't see them acting as financial intermediaries in the credit market. </p>

<p><em> why regulate a hedge fund that buys 5% of shares in a company, but not a private equity firm which buys 51% of the company?</em></p>

<p>Again, the issue is not with equity purchase. The issue lies with entities acting as financial intermediaries for the credit market. To me, it matters not if it's called a hedge fund/partnership, a family office, a corporation, SIV, SPV or a wealthy individual. Anybody who is acting as such, needs to be regulated as such. Getting them to get registered is the only way to know who is doing what.</p>

<p>Wow, just as I finished typing my own words and sort of re-read what's written, I suddenly realized I was going down a scary and dangerous slippery slope. Registering a private citizen's investment portfolio just because he is large enough!? I realize my ideas most likely will not work, and I lack the skills to come up with a feasible solution. Still, the issue is real. It needs to be address.


</p>
 
<p>xtreeter,</p>

<p>Regulation is required when "the little guy" is in a position to be taken advantage of by the industry in question to prevent it from happening. At some point, the amounts invested become large enough that "little" and "big" become relative terms and "Buyer Beware" is the only practical regulating force. The SEC attempted a power grab and was smacked down for being too arbitrary in their application of the law. While hedge funds are huge, they are not easy to get into being both expensive and semi-private. The knock on them that prompted the SEC was that pension funds and other investment agencies were losing money in them and the losing investor claimed fraud. But really... if I tell you that I am accepting investment into the "Nude" fund, but I refuse to tell you the "what, when, where, or why" of my investment strategy, refuse to guarantee a rate of return, and refuse to allow you access to any of my records and yet you still give me your life savings to play with, who's fault is it if *you* end up broke? Would the need for regulation exist if everyone was still making a hefty return on the money?</p>

<p>I feel bad for people who got screwed by their own greed, but when you hand someone else your money, the onus is on YOU to make sure it's a smart choice.</p>
 
<p>The only way to regulate hedge funds is via regulating regulated entities (banks) that do buisness with them. This can be done via regulating the amount of capital banks need to retain against financial exposures to hedge fund clients.</p>

<p>Irvine Renter... about repos... (I haven't read the paper, so maybe out of contaxt):</p>

<p>If I am a bank and I lend to a company, it is not easy to use my claim against the company as collateral for borrowing from someone else. If I lend to a company by buying a security (=a bond), I can easily transfer it to anoth bank I borrow from, to use as collateral. That bank in turn can use that bond as collateral when they borrow from yet another bank. Ech borrowing creates liquidity, and the multiplier is higher with such collaterized lending.</p>
 
<p>Nude,</p>

<p>I have no issue with investors making or loosing money with any vehicle they choose. I have an issue with entities (hedge funds or otherwise) acting as financial intermediaries, levering, multiplying liquidity that resulted in reckless lending which lead to bubbles. My thought was that if we could get some transparency into who is doing what, then anyone acting like a bank should have tiered capital reserve requirements like a bank. </p>

<p>earthbm,</p>

<p>Good idea. Make it so costly for banks that they shy away, or at least think twice before they excessively turbo charge the buy power of hedge funds. A few questions... </p>

<p>What about the good guys in hedge funds? the ones that only arbitrage, only buy/sell equities, etc., and really do no harm to the system?</p>

<p>What about none U.S. banks? They don't need to do any business in the U.S. for their funds to show up in the U.S. markets. </p>
 
IMO, about hedgies... if you can invest in them, then you have the money to lose, and would be just as comfortable in putting it all on black in Vegas. Hedgies do not mess with people who have a measly 6 figures to invest, when they want 7 figures, and big net worth. Anyone who thinks hedgies shift the market is seriously a nutter. While there are those out there making bullish trades,but there are plenty of others on the short side. <a href="http://www.paulsoninvestment.com/">Paulson</a> would give you some amazing triple digit returns. Then those who are not in that category, and are losing money hand over fist.
 
<p>Graphrix,</p>

<p>Bill Gross of Pimco, obviously smarter and more articulate than me, has this to say about "Hedgies" and their brethren's impact:</p>

<p align="justify"><em>"But today’s banking system as pointed out in recent Investment Outlooks, has morphed into something entirely different and inherently more risky. Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders. While margin does flow periodically to balance both party’s accounts, the conduits that hold CDS contracts are in effect non-regulated banks, much like their hedge fund brethren, with no requirements to hold reserves against a significant "black swan" run that might break them. Jimmy Stewart—they hardly knew ye! According to the Bank for International Settlements (BIS), CDS totaling $43 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks.</em></p>

<p align="justify"><em></em></p>

<p align="justify"><em>Defenders might claim no harm, no foul. Theoretically, many of these trillions represent side bets between risk seeking or risk avoiding parties—both adults at a table where the calming benefits of diversification work for the systemic good of all. Originators and existing supporters of these securitized WMDs might also point out that their reserves come in the form of equity and subordinated tranches comprising 10 or 20% of the repackaged loans. They do. But as this equity/subordination shrinks due to underlying defaults, the pyramid begins to unravel. Rating servicer downgrades can and do lead to the immediate liquidation of certain CDOs. The inability to rollover asset-backed commercial paper does and has led to the liquidation of SIVs or, pray tell, a misguided attempt to restructure them as super SIVs. CDOs and even levered municipal bond conduits known as "Tender Option Bonds" have been and will be similarly vulnerable to "Jimmy Stewart-like" runs as the monoline insurers that theoretically stand behind them are themselves downgraded to less than Aaa status.</em></p>

<p align="justify"><em></em></p>

<p align="justify"><em>The withdrawal of deposits from our new age shadow banking system has frightening potential consequences because a thinly capitalized banking system is always at risk relative to its more conservative counterpart. Visualize, as does Chart 1, in crude yet understandable form, today’s shadow system versus that of two decades ago."


</em></p>

<p align="justify"><em></em></p>

<p align="center"><em><img alt="" border="0" src="http://www.pimco.com/NR/rdonlyres/EE32FC02-E13C-403A-B4BD-440DC1AEF050/5224/Chart1.gif" /></em></p>

<p>The report can be seen in its entirety at <a href="http://www.pimco.com">www.pimco.com</a> http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+January+2008.htm</p>
 
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