Topic: Finance, Banking & Monetary Policy

Burrowing In at the Bank — And Your Business Next?

John Cochrane, who is an adjunct scholar at Cato as well as a professor at the University of Chicago Booth School of Business, had a nice post on the evolving nature of modern regulation earlier this month. He starts by quoting a Wall Street Journal account:

Your No. 1 client is the government,” John J. Mack, Morgan Stanley’s chairman and chief executive from 2005 to 2009, told current CEO James Gorman in a recent phone call. Mr. Gorman, who was visiting Washington that day, agreed…

….regulators prowl the office floor looking for land mines, and Mr. Gorman phones Washington before making major decisions…

About 50 full-time government regulators are now stationed at Morgan Stanley. There were none before 2008, when it was regulated as a brokerage firm instead of a bank.

Cochrane adds that this is “a useful anecdote to remind people what ‘regulation’ means.” People often imagine, he says, that it means something like enacting a knowable, impartial equivalent of a speed limit and enforcing it by putting more cops on the road.

No, we put 50 cops in your car. And how long can this possibly go on before the cops start asking where you’re going and why? How long can 50 regulators sit in the bank approving every decision, before “you know, you haven’t made any green energy loans in a long time” starts coming up? But contrariwise, how long before those 50 regulators come to the view that Morgan Stanley’s survival and prosperity is their job? 50 full-time government employees calling the shots on every deal at a supposedly private bank is a good picture to keep in mind of what “regulation” means.

And it isn’t just banking. On-site government inspectors are becoming more common in other lines of business, especially when a company has copped a deal to some earlier charge of regulatory violations – and few big companies have not been hit with charges of that sort. Notre Dame law professor Veronica Root explains what happens next:

…the corporation and the government often enter into an agreement stating that the corporation will retain a “monitor.” … A monitor, unlike the probation officer, is not solely charged with ensuring that the corporation complies with a previously determined set of requirements. Instead, a corporate compliance monitor is responsible for (i) investigating the extent of the wrongdoing already detected and reported to the government, (ii) discovering the cause of the corporation’s compliance failure, and (iii) analyzing the corporation’s business needs against the appropriate legal and regulatory requirements. A monitor then provides recommendations to the corporation and the government meant to assist the corporation in its efforts to improve its legal and regulatory compliance — the monitor engages in legal counseling.

Something to keep in mind next time you wonder why government officials and the leadership of big business so often seem to be working in harness, on issues where you might expect them to oppose each other. 

The Stock Market’s Embarrassing Fall after the Fed Reneged on the Taper

Unlike nearly everyone else, I have argued that the Fed’s latest round of “quantitative easing” is not why stock prices went up until recently, and that “tapering” Fed bond purchases would have had only a negligible effect on long-term interest rates.   

This was a testable hypothesis. If I was wrong, the Fed’s unexpected decision to back away from its previously-expected tapering of bond purchases would have been greeted by a significant, sustained rally in stock and bond prices. That didn’t happen. Instead, stocks fell for at least five days in a row and bond yields barely budged until stocks swooned (triggering a modest flight toward safe havens).

Before the Federal Reserve’s “surprise” at 2 p.m. on Wednesday September 18, nearly every financial reporter was confident the yield on 10-year Treasuries had increased to 2.86 percent from 1.66 percent in early May, simply because Fed officials hinted in May that they might begin to slow the pace of bond-buying by September. If that story had been true, we should have expected bond yields to retrace most of their rise as soon as the Fed removed that fear of the taper. Instead, the 10-year bond yield ended the week of the Fed announcement at 2.75 percent – no lower than the average yield in August (2.74) and merely a trivial 11 basis points lower  than the day before the Fed’s surprise.

Financial analysts and reporters were likewise certain the stock market had been terrified about the possible taper before September 18. If that was true, stocks should have soared for days or weeks on the supposedly terrific news that a taper was off the table. On the contrary, U.S. stocks were rising briskly for many days before the Fed meeting, but have since fallen persistently. A few hours of speculative stock gains on Wednesday the 18th were more than erased by Friday the 20th and stocks kept falling the following Monday, Tuesday and Wednesday.

Reporters and analysts who claimed stocks had been shored up by quantitative easing were logically obligated to expect a stock boom from the Fed’s message of no change. When stocks instead moved in the wrong direction, baffled reporters tried to blame their bad forecasts on mysterious “uncertainties” about the taper although there is obviously less uncertainty now than before.

Anyone who bases investment decisions on trendy theories that fail to predict what actually happens is either a poor journalist or a poor investor who pays undue attention to poor journalists. The market’s thumbs down vote on the Fed’s gutless decision to stick with quantitative easing provides added evidence that QE never helped stocks or the economy, and that ending such an obviously unsustainable policy will one day be welcomed as the good news that it really will be.

Rouhani Delivers Lower Inflation, and other Troubled Currencies Project Updates

Iran: Prior to Hassan Rouhani’s election as Iran’s new president in June, the black-market Iranian rial to U.S dollar (IRR/USD) exchange rate stood at 36150, implying an annual inflation rate of 109 percent (June 15th 2013). Since Rouhani took office, Iranian expectations about the economy have turned positive, or at least less negative, and the black-market IRR/USD exchange rate has strengthened to 29200. In consequence, the implied annual inflation rate has fallen like a stone, and currently sits at 20 percent. That’s even lower than the most recent official annual inflation rate of 35.1 percent. (August 2013).

Rouhani has stated that one of his top priorities is to set the Iranian economy right. So far, it appears the new president has delivered the goods.

Venezuela: September got off to a rocky start in Venezuela. On September 4th, the World Bank’s International Center for the Settlement of Investments Disputes announced that Venezuela had illegally expropriated ConocoPhillips’s multi-billion dollar crude oil projects. This coincided with a massive blackout that left half the country without power. To top it off, price controls have led to worsening shortages, with the government announcing on September 13th that the shortage index had hit a whopping 20 percent for the month of August. All of this bad news is reflected in Venezuelan’s economic expectations, as measured by the black-market exchange rate for the Venezuelan bolivar (VEF).

From beginning of the month through September 17th the VEF/USD exchange rate depreciated by 16.3 percent, from 37.32 to 44.59. In consequence, the implied annual inflation rate rose from 230 percent to a high of 292 percent.

Things took a turn for the positive on September 18th, when Venezuela and China agreed to a $14 billion investment package, which includes joint venture to develop the Junin 10 bloc of the Orinoco Oil Belt, as well as investments in mining, transportation and agricultural projects in Venezuela. In consequence, the black-market VEF/USD exchange rate has fallen to 44.03, yielding an annual implied inflation rate of 261 percent.

Argentina: Despite some recent good economic news, Argentineans still appear to be skeptical about their economy’s future. On Friday, September 20, Argentina announced a strong 8.3 percent year-over-year growth rate for Q2. One would think this strong performance would have improved Argentinean’s expectations for the economy, as measured by changes in the peso’s black-market U.S. dollar exchange rate. But, the black-market exchange rate has held steady in the days since the announcement. The current black-market ARS/USD exchange rate sits 9.43, yielding an implied annual inflation rate of 50 percent. It appears that concerns of ongoing inflation troubles are still weighing heavy on the minds of Argentineans.

Egypt: Since the Egyptian military ousted Mohammed Morsi on July 3rd, the Egyptian pound’s (EGP) official and black-market U.S. dollar exchange rates have converged. Currently, the black-market rate sits at 7.10 EGP/USD – very close to the official exchange rate of 6.89 EGP/USD. These rates have been stable for the past month.

Prior to the military takeover, the black-market exchange rate sat at 7.6 EGP/USD. Since Morsi’s ouster, the pound has appreciated by 7 percent, to 7.10 EGP/USD. This yields a current implied annual inflation rate of 18 percent, down from 28 percent in the final days of the Morsi government.

Yes, it appears the Egyptian generals have delivered some semblance of stability on the economic front. Indeed, the black market for foreign exchange has all but disappeared.

Syria: As President Obama heads to the United Nations General Assembly to iron out the terms of a tentative Syrian chemical weapons deal, the black-market exchange rate for the Syrian pound (SYP) continues to hold steady at 206. Currently, the implied annual inflation rate in Syria sits at 189 percent. This is down from a high of 291 percent on the 28th of August, when Secretary of State John Kerry kicked off the United States’ abortive march to war.

For up-to-date information on these countries and their troubled currencies, see the Troubled Currencies Project.


Does Janet Yellen Know What a Bubble Looks Like?

With Larry Summers withdrawing from the race for Federal Reserve chair, current Fed vice chair Janet Yellen has pulled into the lead to become Ben Bernanke’s replacement. Previous to her current appointment, Yellen served as president of the San Francisco Federal Reserve Bank  The SF Fed’s district includes three of the worst states in the housing crisis – California, Arizona and Nevada.  I think its fair to say that without the housing boom and bust in these states we wouldn’t have had a mortgage crisis.  Given that Yellen was the top banking regulator for this geography, one has to wonder whether she was asleep at the wheel.  

This issue wasn’t ignored at her confirmation hearing for Fed vice chair.  Here’s a little of her exchange with Sen. Richard Shelby (R-Ala.):

SHELBY: And regarding your tenure as president of the 12th District, I have two questions. First, what role do you believe a breakdown in regulatory oversight played in the failure of the institutions in your district? And secondly, were you raising any warning flags with respect to speculative excesses or lax monetary policy during that period?

YELLEN: So the first question was to the breakdown – to the breakdown in…

SHELBY: Do you believe a breakdown in regulatory oversight – what role do you believe that a breakdown in regulatory oversight played in the failure of the institutions in your district?

YELLEN: Working with other regulators, I think that our regulatory oversight was careful and appropriate, but I believe that the…

SHELBY: Well, excuse me. You say it’s careful and appropriate, and you – most people believe…

YELLEN: Given the…

SHELBY: … it was lax and inappropriate.

YELLEN: Well, I – in the institutions that have failed in my district are mainly community banks with high exposure to commercial real estate.


YELLEN: And when I say careful and appropriate, I mean that as early as 2001…


YELLEN: … people in the Federal Reserve System, and particularly in my bank, were at the forefront of focusing on high concentrations that existed in the banks we supervised in commercial real estate. We saw that these exposures and concentrations could be a source of vulnerability, and we monitored this carefully throughout.

Interestingly enough she never touches on the topic of monetary policy and its impact on housing prices.  When the Fed hasn’t been complicit in generating bubbles, they’ve generally just turned a blind eye to them.  If one cannot from the perch of San Francisco identify the perverse impact of loose money on housing prices, then you’re likely to miss it from D.C. as well.

If you think bubbles are a great avenue for wealth creation, then Yellen is the Fed chair for you.  If you, however, suspect bubbles are damaging to our economy, then you might rightly be concerned that she repeats her San Francisco performance on a national level.

The Reynolds Model of Stock Prices

Mark Hulbert’s latest Wall Street Journal column criticizes

the so-called Fed Model, which holds that P/E ratios should rise as interest rates decline, and vice versa. The strategy got its name in 1997, following a reference in a Federal Reserve report to the tendency of the S&P 500’s earnings yield—the inverse of its P/E ratio—to rise and fall with long-term interest rates.  During the 15 years before the Fed made that observation, the U.S. stock market’s P/E ratio did indeed tend to be higher when interest rates were low, and vice versa, Mr. [Javier] Estrada concedes. But, he points out, that relationship hasn’t held up as well since then, raising the possibility that the apparent correlation might have been just a coincidence.  Further doubts came when Mr. Estrada analyzed U.S. experience over the 100 years before 1980.

I may have discovered “the Fed Model” in March 1991– long before Ed Yardeni gave it that name after July 22,1997. The relationship between the inverted P/E ratio and bond yields was first depicted in the letter below to consulting clients (institutional investors), where I probably should have labeled it the “Reynolds Model.”

I agree with Estrada that it did not work very well before August 15, 1971, when the last remnants of the gold standards were abandoned. The gold standard did not permit the extreme gyrations in bond yields we have seen between Fed Chairmen Volcker and Bernanke.  Relatively steady bond yields of 2-5 percent from 1789 to 1970 under a gold standard obviously tell us little about stock market booms and busts at that time. Contrary to Hulbert and Estrada, however, the U.S. relationship between the e-p ratio and the 10 year bond yield remained remarkably tight from 1970 to 2008. From 1988 to 2008, the e-p ratio averaged 4.9 and the 10-year bond averaged 6 percent.

For reasons I recently discussed in Barron’s, the Reynolds Model also failed during recent years of “quantitative easing,” when the Fed began massive purchases of government bonds.  Today, the e-p ratio is slightly higher than the 1988-2008 average (5.4), which means the p-e ratio is lower, even though the 10-year bond is only half the recent norm. What the Reynolds Model tells us is the e-p ratio is not low, and the p-e ratio is likewise not high, unless the interest rate on 10-year bonds rises to at least 5 percent (which seems unlikely so long as nominal GDP keeps growing more slowly than that).

Stock prices have risen because of rising earnings, not because of a high multiple of stock prices to earnings.  Any downside risks are far more likely to come from shocks to earnings (such as another oil price spike) rather than some spontaneous decline in multiples.

S&P’s Dilemma: Rating your Regulator

In a court filing today, the rating agency Standard & Poor’s (S&P) claims that the federal case against them is motivated by retaliation for its 2011 decision to strip the United States of its “AAA” credit rating.  

It might be easy to dismiss this claim, but they aren’t the only ones in this situation. Before S&P’s U.S. downgrade, the smaller firm Egan-Jones, which relies on a subscriber model also downgraded the United States. Not long after, Egan-Jones was investigated by the SEC and ultimately barred for a time from rating U.S. debt. Let’s remember that Egan-Jones was ahead of the curve in spotting both the subprime bubble and the failures of WorldCom and Enron.

If you didn’t downgrade the United States, what happened? Basically nothing. We see what starts to look like a pattern here: downgrade the United States and expect some abuse. Don’t and you will be largely left alone. And as the recent IRS treatment of Tea Party groups has shown: this administration isn’t above targeting its enemies.

There are, as expected, several twisted ironies to the case. First, the Department of Justice is claiming to act on behalf of banks that suffered losses from holding rated securities. But who was it that imbedded ratings into the bank regulatory process? The bank regulators. If the DOJ wants to punish someone for bank losses on rated securities it should start with the Basel Committee. And then there’s the DOJ itself, which uses a flawed theory of disparate impact to pressure banks to make bad loans in the first place. The DOJ doesn’t have to go far to find the guilty: just try looking in a mirror.

The solution here is ultimately to get the federal government out of regulating the rating agencies. Our entire financial system is built on sovereign debt. The crisis in Europe shows what happens when you get the treatment of sovereign debt wrong (for a good summary of sovereign risk in bank regulation, see this BIS speech). The conflicts of interest between raters and regulators are ultimately a far greater threat to our system than any conflict between corporate issuers and raters.

The Syrian Pound Zigs and Zags

Following U.S. Secretary of State John Kerry’s saber-rattling statements on the 26th of August, the value of the Syrian pound (SYP) has zigged and zagged. Indeed, the SYP lost 24.7% of its value against the U.S. dollar in the two days following Kerry’s announcement (moving from 225 to 270 SYP/USD). Then, yesterday, we saw a sharp reversal in the course of the pound. Over the past two days, the SYP regained 25.58% of its value, bringing the black-market exchange rate back down to 215 SYP/USD. At this rate, the implied annual inflation rate is 209.85% (see the charts below the jump).

So, what caused the recent strengthening of the Syrian pound? We have to look no further than the eroding support for a U.S.-led strike against Syria. Yes, the United States has lost support from important allies, the United Kingdom, Canada, and Italy.

In addition, Syrian authorities have cracked down again on black-market currency trading. In the past week, the authorities have shut down a number of currency traders; made “friendly” reminders to the public of the penalties of trading on the black market—imprisonment of 10 years and a hefty fine; and warned Syrians to stay away from “counterfeit” dollars that have supposedly been circulating. The authorities’ “get tough” policy followed speculation that the SYP/USD rate would surpass the 300 mark.

I have established a page to track current black-market exchange-rate and implied inflation data for the Syrian pound, as well as for troubled currencies in Iran, Argentina, North Korea, and Venezuela. For more, see: The Troubled Currencies Project.